Do 'Sophisticated' Investors Believe in the Law of Small Numbers?

Believers in the law of small numbers tend to over-infer the outcome of a random process after a small series of observations. People tend to believe that small samples replicate the probability distribution properties of the population. This paper provides empirical evidence on whether investors are mistakenly driven by this psychological bias when facing the decision to hire or fire a fund manager. Using quarterly data between 1994 and 2000 from a sample of 752 hedge funds, we look at investment and divestment decisions of investors after a fund manager has displayed a successful (or losing) streak. Our results show that even sophisticated investors exhibit a 'hot-hand' bias that may seriously harm their wealth. For more information: contact Peter Roosenboom (proosenboom@rsm.nl)