What's Causing Overreaction? An Experimental Investigation of Recency and the Hot Hand Effect

A substantial body of empirical literature provides evidence for overreaction in markets. Past losers outperform past winners in stock markets as well as in sports markets. Two hypotheses are consistent with this observation. First, the recency hypothesis states that traders overweigh recent information. Thus, they are too optimistic about winners and too pessimistic about losers. Second, the hot hand hypothesis states that traders try to discover trends in the past record of a firm or a team, and thereby overestimate the autocorrelation in the series. An experimental design allows us to distinguish between these hypotheses. The evidence is consistent with the hot hand hypothesis. Experience slightly reduces the observed phenomenon of overreaction. JEL codes: D84, G12, C91. Key-words: overreaction, recency, hot hand, scoring rule, experiments. Current version: January 2000 ** University of Amsterdam CREED / Department of economics Roetersstraat 11 1018 WB Amsterdam Netherlands e-mail: [email protected] e-mail: [email protected] * We would like to thank Uri Gneezy, Jan Potters, Arthur Schram, Randolph Sloof and Jörgen Wit for useful comments. The authors gratefully acknowledge financial support from NWO. Part of this work was completed while Theo Offerman worked at Tilburg University.