Working Paper: CEPR ID: DP6081
Authors: Matthew Rabin; Dimitri Vayanos
Abstract: We develop a model of the gambler's fallacy -- the mistaken belief that random sequences should exhibit systematic reversals. We show that an individual who holds this belief and observes a sequence of signals can exaggerate the magnitude of changes in an underlying state but underestimate their duration. When the state is constant, and so signals are \textit{i.i.d.}, the individual can predict that long streaks of similar signals will continue -- a hot-hand fallacy. When signals are serially correlated, the individual typically under-reacts to short streaks, over-reacts to longer ones, and under-reacts to very long ones. We explore several applications, showing, for example, that investors may move assets too much in and out of mutual funds, and exaggerate the value of financial information and expertise.
Keywords: behavioral finance; gamblers fallacy; hot hand fallacy
JEL Codes: D8; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| gamblers fallacy (H27) | exaggerated magnitude of changes in underlying state (C32) |
| gamblers fallacy (H27) | underestimated duration of changes in underlying state (C41) |
| gamblers fallacy (H27) | hot hand fallacy (G41) |
| hot hand fallacy (G41) | overreaction to long streaks of signals (E32) |
| hot hand fallacy (G41) | underreaction to short streaks of signals (G41) |
| cognitive biases (D91) | overtrade in mutual funds (G23) |
| cognitive biases (D91) | overestimate value of financial information (G41) |