Do Sophisticated Investors Believe in the Law of Small Numbers?
Author InfoBaquero, G. Verbeek, M.J.C.M. Abstract Believers in the law of small numbers tend to overinfer the outcome of a random process after a small series of observations. They believe that small samples replicate the probability distribution properties of the population. We provide empirical evidence indicating that investors are mistakenly driven by this psychological bias when hiring or firing a fund manager after a successful (or losing) performance streak. Using quarterly data between 1994 and 2000 of 752 hedge funds, we analyze actual money flows into and out of hedge funds and their relationship with the length of the streak. We first show that persistence patterns have a predictive ability of future relative performance of a manager: the longer the winner streak, the larger the probability for a fund to remain a winner. Investors, in turn, appear to be aware of quality dispersion across managers and respond by following a momentum strategy: the longer the winning (losing) s
