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Saturday 10 April 2010

Recency: Hot-Hands and the Gambler's Fallacy

Behavioural Biases (6): Recency

Recency is a great trouble to us, being a particularly tricky sort of behavioural bias that’s rather difficult to overcome. It works thus: you overfocus on the most recent events you’ve experienced and neglect to worry about older information. We don’t so much integrate new information with the old as use it to overwrite our memories.

For investors recency may have a couple of different effects. Positive recency makes you a momentum trader, a sort of living incarnation of a goldfish, forever surprised by the same piece of seaweed. Negative recency makes you a contrarian investor, solidly heading away from anything exciting, looking for where the action isn’t. Either way you’d better be damn sure you know what you’re doing because both approaches more or less guarantee under-diversification.

Assuming the Serial Position

Recency is a special case of what’s known as the serial position effect, a finding that the order in which information is presented matters greatly to our ability to recall it from memory. To be precise the first items in a list are generally remembered – the primacy effect – and the last ones, the recency effect. Mostly we either fail to remember or misremember the stuff in the middle.

However, the recency effect doesn’t generally just refer to remembering stuff from lists, it’s also used to refer to an autobiographical effect in which people tend to remember stuff that’s happened to them recently more vividly than things that happened further back in the past. It’s pretty darned obvious how this can apply to investors, as the remembrance of recent events is likely to overwhelm a longer-term view. Given the essentially random nature of short-term returns on stockmarkets being driven by the recency effect isn’t likely to lead to happy investing returns.

Hot-Hand or Gambler?

Positive and negative recency are both observable in normal human behaviour. Perhaps the most common forms of these appear in the “hot-hand effect” and the “gambler’s fallacy” respectively. In the former people erroneously believe that players in certain sports get on a roll and demonstrate a run of success over and above what they’d normally achieve. In the latter there’s an expectation that a run of a particular type in a random process makes a reversion more likely – so a run of red on a roulette wheel makes black more likely next time.

In fact people can demonstrate both positive and negative recency at the same time about the same thing. In a neat experiment Peter Ayton and Ilan Fischer used random data from roulette wheel games to show that participants committed the gambler’s fallacy in predicting the outcome of sequences of spins yet simultaneously believed that their predictions – based on the same random data – were affected by the hot hand effect.

Random Stuff Doesn’t Just Happen

Underlying this, the researchers speculate, is the natural belief that random processes can’t exhibit long runs of identical outcomes by chance so people invoke human skill to explain these results. Some of this may be directly related to our limited experiences of the world – when random stuff happens it’s not under human control but when order appears it generally does. So when we’re presented with a large amount of essentially random statistical data which appears to generate patterns it’s perhaps not surprising that we read into it more than is actually there.

Unfortunately “being presented with a large amount of essentially random data which appears to generate patterns” comes close to being a definition of the outcomes of stockmarkets. In investing, then, it looks like we’re being forced to co-habit with a beast that doesn’t really behave in the way that we’re trained to expect. So when we find patterns in the randomness we generally ascribe these to human skill, either through negative recency – the expectation that a market or a stock will turn after a run in a certain direction – or positive recency – the belief that a run of successful returns are the result of human skill rather than coin-tossing expertise.

Indeed there’s even a suggestion that widespread belief in the gambler’s fallacy is the cause of the hot-hand effect. The idea is that because we don’t expect long-term sequences to be generated by luck and anticipate a reversal when someone does manage to hit a lucky streak we’re even more inclined to think that this is skill. The whole topic is like being trapped in a hall of mirrors with your identical twin.

Momentum and Mean Reversion

Although these random effects are evident at the level of individual investor psychology the question about whether there really is recency in markets is another matter. Momentum effects, where a stock which has moved in one direction is likely to continue moving in the same direction, are an obvious analogue of positive recency. Meanwhile negative recency is strongly associated with a belief in mean reversion, where various trends suddenly stop working. Both effects are seen frequently in markets and there seems to be genuine evidence for them over different time frames – value stocks outperform growth stocks and recent winners outperform recent losers.

Shifrin and Belotti identify some evidence that the hot-hand and gambler’s fallacies tend to affect different groups of investors in different ways:
“Many [private] investors form judgments that suggest that they mistakenly believe that risk and return are negatively related. In contrast, the judgments underlying analysts’ target prices are consistent with risk and return being positively related. At the same time, analysts appear to make some errors in judgment when setting target prices. In particular, analysts establish target prices as if they expected growth stocks to outperform value stocks and recent losers to outperform recent winners.”
This, of course, is quite brilliant. Different groups of investors are impacted by recency in different ways over different time periods and both end up making a complete hash of the investing game. In fairness it should be pointed out that professionals are generally affected by the perverse incentives of their particular remuneration models. Private investors have no such excuse.

Random Walking Back To Happiness

There is another possible explanation of recency effects in markets. Recency can only apply if the returns on markets are genuinely random. If underlying all of this behavioural confusion there are genuine patterns then recency doesn’t apply because if tomorrow’s prices are predictable in some way from today’s then the randomness disappears – maybe a red on this spin predicts a black on the next. Or is it the other way around?

Anyway, for the most part this doesn’t matter – stockmarkets and their constituents are essentially following a random walk, staggering around without much of an idea what to do next. Only by focusing on the basics of valuation and trying to eliminate the chances of bad luck through a significant margin of error can we hope to achieve outsize returns through a semblance of skill. It is possible, as a few of the world’s great investors have shown, but only by focusing on negative recency. Get this wrong, however, and you’re committing the gambler’s fallacy. It’s a tough old game, this investing lark, ain’t it?

Previous Article: Anchoring, The Mother of Behavioral Biases

Next Article: Confirmation Bias, The Investor's Curse


  1. There's a story on this theme told in the book A Random Walk Down Wall Street that drives me a little nuts. It's a fantastic illustration of the point if it is true. But it is hard for me to accept that it is really true.

    The question was whether basketball players can experience a "hot hand" or not. The argument was that we only perceive them to have a hot hand, that statistical tests can be done showing that we see the number of "hot hands" that we would see if all hands were neither hot nor cold but just performing according to their skill level (which of course vary).

    This is entirely counter-intuitive. I certainly feel that I have a hot hand on some nights when I shoot baskets with my boys and not on other nights. Could it be that I am imagining things?


  2. Interesting point because I always wonder how people define things. Is a "hot hand" when you make a greater percentage of your first 10 shots of the game? Or is a "hot hand" the probability that you will make your next basket given that you have made 2 baskets in a row?
    Also coaches don't believe wholly in the "hot Hand" concept. When a technical foul is called late in the game they send the shooter with the best overall shooting percentage to the line - not the one that is having a hot hand that night.

  3. that's pretty interesting