Seven deadly sins of investing: Part 2 - The hot-hand fallacy

We continue Plato's seven deadly sins series of investor notes, where we look at behaviours that can quietly and repeatedly destroy wealth. 

We know them well. We have committed every one of them, and probably always will. The hope is simple: awareness does not eliminate bias, but it can reduce its influence and improve decision-making.

Our hard-wiring

Humans are hard-wired to search for patterns and impose order on a world that is often chaotic and senseless. Perhaps this springs from a deep desire to feel in control of our lives. Whatever its source, the instinct is powerful enough that we often see structure where none exists.

Consider the following sequences of coin tosses, where H is heads and T is tails. 

Which sequence is random, and which is artificial? 

Take a moment to study them.

1. HHTHTHTTTHHTHTHHTTHTHTHTHTTHTHHTHTHHTTHT
   
2. HTTTTHHHTHHHHHHTTHTHTTTTHTHTHHHTHTHTHTTH
   

Most people choose the first sequence as random, and the second as artificial, because the second contains too many long runs of consecutive heads and tails. 

In fact, the opposite is true: sequence (1) is artificial, while sequence (2) came from a fair coin.

Our intuition about randomness is remarkably poor. We expect it to look more orderly, and more evenly mixed, than it really does.

This tendency was famously documented in the classic 1985 cognitive psychology paper, The Hot-Hand in Basketball: On the Misperception of Random Sequences. 

The hot-hand fallacy 

Who among us has not watched a game and become convinced that a player is “on fire” and simply cannot miss? Studying hundreds of NBA games, the authors found that the probability of a player making the next shot after making a basket was not any different than after a miss. 

This became known as the hot-hand fallacy. Since then, similar illusions of streaks have been documented in baseball, tennis, and many other sports. 

The key point is that the chance of winning the next point is driven far more by the player’s long-run base rate than by what happened in the previous few moments.

The hot-hand fallacy is just as pervasive in financial markets. Investors often assume that a fund ranked in the top quartile one year is far more likely to remain a top performer the next.

When was the last time you invested in a bottom quartile performing fund? 

In reality, there is very little persistence in annual relative performance, as value and growth styles fall in and out of favour.

Arguably the most dangerous version of this mistake is the belief that exceptional revenue and earnings growth can persist for many years. In competitive markets, companies rarely sustain market-beating growth rates for more than a year or two before competition, saturation, and simple mean reversion take hold.

Revenue growth rates rarely last forever

Many years ago, we conducted a simple piece of research that illustrates the folly of extrapolating growth too far into the future. 

The chart below shows the performance of an investment strategy that, at the start of each year, buys the global companies with the highest revenue growth rates. 

If you had invested $100,000 in that strategy 30 years ago, by the end of 2025 you would have had virtually nothing left.

Why? Because growth rates mean-revert far more quickly than investors expect, while valuations are driven to unsustainable levels by the assumption that recent success will continue indefinitely. Investors do not merely admire growth; they habitually over-extrapolate it.

That is why one of Plato’s 150 Red Flags is a company with extreme growth expectations. 

Market darlings with rosy narratives and heroic long-term assumptions can be especially dangerous. When expectations become too optimistic, even very good businesses can become very poor investments.

Current examples include: 

• Guzman y Gomez (ASX: GYG) - forecasting 10,000 stores, the same as McDonalds, in Australia in 20 years time.
  
• Tesla (NASDAQ: TSLA) - targeting 10 billion humanoid robots by 2040
  
• Atlassian (NYSE: TEAM) - forecast to grow revenue from $5.7b to $11.3b despite the potential for SaaS-apocalypse to erode software moats). All are shorts and/or underweights for Plato Global Alpha.
  

Read Part 1 or the series here:

Education

Seven deadly sins of investing: Part 1

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Dr David Allen is Plato Investment Management's Head of Long/Short Strategies and Portfolio Manager of the Plato Global Alpha Fund. 

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