Let me tell you about a classic psychological study that I found online and has important insight for us as traders and investors.
In the early 1980s, two psychologists Amos Tversky and Thomas Gilovich began sifting through years of statistics from the Philadelphia 76ers – a US basketball team. (Amos Tversky is well known for his ground breaking research with Daniel Kahneman on making judgments in uncertain environments based on heuristics and biases which has lead to a whole new field in finance called ‘behavioural finance’.) The psychologists looked at every single shot taken by every single player, and recorded whether or not that shot had been preceded by a string of hits or misses. All told, they analyzed thousands upon thousands of field goal attempts.
Tversky and Gilovich were interested in testing the “hot hand” phenomenon, which occurs when NBA players are convinced that they’re ‘hot’, on a ‘roll’ or, in ‘the zone’. While players, coaches and spectators were convinced the hot hand was real, the psychologists knew that humans are notoriously bad at detecting “streaks”. After all, we’re the same species that gets convinced we’re playing a “hot” poker machine or enjoying a ‘purple patch’ on a roulette wheel.
After analyzing all the shots of the 76ers, the psychologists discovered that there was absolutely no evidence of “the hot hand.” A player’s chance of making a shot was not affected by whether or not their previous shots had gone in; each field goal attempt was its own independent event. The short runs (of goals or missed attempts) experienced by the 76ers were no different than the short runs that naturally emerge from any random process. Bagging a goal was just like flipping a coin. The streaks were a figment of our imagination, and each event is random in its outcome, and completely unrelated to all previous outcomes.
The 76ers were shocked by the evidence. Andrew Toney, the shooting guard, was particularly hard to convince: he was sure that he was a “streaky” shooter, and went through distinct “hot” and “cold” periods. But the statistics told a different story. During the regular season, Toney made 46 percent of all of his shots. After hitting three shots in a row – a sure sign that he was now “in the zone” – Toney’s field goal percentage dropped to 34 percent. When Toney thought he was “hot,” he was actually freezing cold. And when he thought he was cold, he was just getting warmed up: after missing three shots in a row, Toney made 52 percent of his shots, which was significantly higher than his normal average.
But maybe the 76ers were a statistical outlier. After all, according to a survey conducted by the scientists, 91 percent of serious NBA fans believed in “the hot hand”. They just knew that players were streaky. So Tversky and Gilovich decided to analyze another basketball team: the Boston Celtics. This time, they looked at free throw attempts, and not just field goals. Once again, they found absolutely no evidence of hot hands. Larry Bird ( a Celtics player) was just like Andrew Toney: After making several free throws in a row, his free throw percentage actually declined. The study also indicated that after a string of goals Bird got complacent, and started missing shots he should have made!!
Why, then, do we believe in the hot hand? Confirmation bias is to blame. Once a player makes two shots in a row – an utterly unremarkable event – we start thinking about the possibility of a streak. Maybe he’s hot? Why isn’t he getting the ball? It’s at this point that our faulty reasoning mechanisms kick in, as we start ignoring the misses and focusing on the makes. In other words, we seek out evidence that confirms our suspicions of streakiness. The end result is that a mental fiction dominates our perception of the game.
All of this evidence has important points for us as traders. Often when we are convinced we are on a winning streak, people will do random things like increasing position sizing and taking higher risks, only to find that a losing streak occurs that does hefty damage to their account and their psychological state. It also highlights the fact that the outcome of each and every trade is random and completely separate from any other trade that has preceded it and any that will follow.
Next week, we will delve a little further into this psychological study and examine further aspects of confirmation bias and the random outcome of events, and the impact these can have on our trading results if they are not fully understood and managed.