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Surprised by the Gambler's and Hot Hand Fallacies? A Truth in the Law of Small Numbers

Number: 552
Year: 2015
Author(s): Joshua B. Miller and Adam Sanjurjo
We prove that a subtle but substantial bias exists in a standard measure of the conditional dependence of present outcomes on streaks of past outcomes in sequential data. The magnitude of this novel form of selection bias generally decreases as the sequence gets longer, but increases in streak length, and remains substantial for a range of sequence lengths often used in empirical work. The bias has important implications for the literature that investigates incorrect beliefs in sequential decision making - most notably the Hot Hand Fallacy and the Gambler's Fallacy. Upon correcting for the bias, the conclusions of prominent studies in the hot hand fallacy literature are reversed. The bias also provides a novel structural explanation for how belief in the law of small numbers can persist in the face of experience.

Keywords: Law of Small Numbers; Alternation Bias; Negative Recency Bias; Gambler's Fallacy; Hot Hand Fallacy; Hot Hand Effect; Sequential Decision Making; Sequential Data; Selection Bias; Finite Sample Bias; Small Sample Bias
JEL codes: C12; C14; C18;C19; C91; D03; G02