Do Sophisticated Investors Believe in the Law of Small Numbers?

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. Using quarterly data between 1994 and 2000 of 752 hedge funds, we look at investment and divestment decisions of investors after a successful (or losing) streak of a fund manager. Apparently, sophisticated investors exhibit a quot;hot-handquot; bias that may seriously harm their wealth