Overweighing Recent Observations: Experimental Results and Economic Implications

We conduct an experimental study in which subjects choose between alternative risky investments. Just as in the “hot hands” belief in basketball, we find that even when subjects are explicitly told that the rates of return are drawn randomly and independently over time from a given distribution, they still assign a relatively large decision weight to the most recent observations — approximately double the weight assigned to the other observations. As in reality investors face returns as a time series, not as a lottery distribution (employed in most experimental studies), this finding may be more relevant to realistic investment situations, where a temporal sequence of returns is observed, than the probability weighing of single-shot lotteries as suggested by Prospect Theory and Rank Dependent Expected Utility. The findings of this paper suggests a simple explanation to several important economic phenomena, like momentum (the positive short run autocorrelation of stock returns), and the relationship between recent fund performance and the flow of money to the fund. The results also have important implications to asset allocation, pricing, and the risk-return relationship.