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The gambler's and hot-hand fallacies: theory and applications

Rabin, Matthew and Vayanos, Dimitri (2007) The gambler's and hot-hand fallacies: theory and applications. Discussion paper, 578. Financial Markets Group, London School of Economics and Political Science, London, UK.

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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 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.

Item Type: Monograph (Discussion Paper)
Official URL: http://fmg.lse.ac.uk
Additional Information: © 2007 The Authors
Library of Congress subject classification: H Social Sciences > HB Economic Theory
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Collections > LSE Financial Markets Group (FMG) Working Papers
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: 578
Date Deposited: 22 Jul 2009 08:45
URL: http://eprints.lse.ac.uk/24476/

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