As more references to Kahneman’s work are coming up in the current sequence of new posts, it seemed worthwhile republishing another angle on his impressive work. This is the last of two posts: the first was posted yesterday.
In the previous post we looked at the general picture of investor performance Kahneman paints from the research he has examined. Now we can look a little more closely at what lies behind that overview.
There were exceptions to this general trend in that (3856) ‘the most active traders had the poorest results, while the investors who traded the least earned the highest’ and (3857) ‘men acted on their useless ideas significantly more often than women, and that as a result women achieved better investment results than men.’
The main source of this poor performance resides in one pattern in particular (3861-3862):
Individual investors like to lock in their gains by selling “winners,” stocks that have appreciated since they were purchased, and they hang on to their losers. Unfortunately for them, recent winners tend to do better than recent losers in the short run, so individuals sell the wrong stocks.
The Persistent Achievement Test
There is also another way of looking at this situation. Persistent achievement is a basic test of skill which (3867) ‘Professional investors, including fund managers, fail.’
He is very confident of the truth of this statement (3873):
. . . . the evidence from more than fifty years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker.
This has an impact on investments in general (3874): ‘Typically at least two out of every three mutual funds underperform the overall market in any given year. ‘
This is not a very flattering state of affairs for the pundits (3877):
There is general agreement among researchers that nearly all stock pickers, whether they know it or not—and few of them do—are playing a game of chance. The subjective experience of traders is that they are making sensible educated guesses in a situation of great uncertainty. In highly efficient markets, however, educated guesses are no more accurate than blind guesses.
Kahneman’s Own Research
Kahneman’s own research confirms this view. He was invited to investigate the figures of a firm to whom he had been invited to speak. He was given access to (3882) a ‘spreadsheet summarizing the investment outcomes of some twenty-five anonymous wealth advisers, for each of eight consecutive years.’
He took the first basic step in this assessment of skill (3884):
It was a simple matter to rank the advisers by their performance in each year and to determine whether there were persistent differences in skill among them.
The rank ordering allowed for the calculation of how well each person’s rank held up over the whole time period studied. The more consistent people were the stronger the correlations would be between each year’s figures. He created ‘28 correlation coefficients, one for each pair of years.’
Then came the surprise (3887):
I knew the theory and was prepared to find weak evidence of persistence of skill. Still, I was surprised to find that the average of the 28 correlations was 0.01. In other words, zero.
Which meant, in effect (3889), that ‘[t]he results resembled what you would expect from a dice-rolling contest, not a game of skill.’
Conclusions about the Illusion of Skill in General
‘The illusion of skill’ (3899) is a deeply embedded one.
It is also deeply misplaced. He explains (3922):
Unfortunately, skill in evaluating the business prospects of a firm is not sufficient for successful stock trading, where the key question is whether the information about the firm is already incorporated in the price of its stock.
What we learn from carefully analyzed data is that (3958):
. . . . people who spend their time, and earn their living, studying a particular topic produce poorer predictions than dart-throwing monkeys who would have distributed their choices evenly over the options. Even in the region they knew best, experts were not significantly better than nonspecialists.
And it gets worse (3963):
In this age of academic hyperspecialization, there is no reason for supposing that contributors to top journals—distinguished political scientists, area study specialists, economists, and so on—are any better than journalists or attentive readers of The New York Times in ‘reading’ emerging situations.
Two Important Lessons
He feels that two important lessons need to be learned from all this (3982):
The first lesson is that errors of prediction are inevitable because the world is unpredictable. The second is that high subjective confidence is not to be trusted as an indicator of accuracy (low confidence could be more informative).
With co-workers he investigated where the border falls between what we can and what we cannot predict (4339-4347):
If subjective confidence is not to be trusted, how can we evaluate the probable validity of an intuitive judgment? When do judgments reflect true expertise? When do they display an illusion of validity? The answer comes from the two basic conditions for acquiring a skill:
- an environment that is sufficiently regular to be predictable
- an opportunity to learn these regularities through prolonged practice. . . . .
Physicians, nurses, athletes, and firefighters . . . face complex but fundamentally orderly situations. The accurate intuitions . . . described are due to highly valid cues that the expert . . . has learned to use. . . In contrast, stock pickers and political scientists who make long-term forecasts operate in a zero-validity environment. Their failures reflect the basic unpredictability of the events that they try to forecast.
How are we to move from fire fighting, in what seems a losing battle sometimes, to effective fire prevention in this aspect of human affairs?
The Bahá’í position on the development of societies casts an interesting light on this, and is, I feel, validated by both Taleb’s and Kahneman’s analyses. A recent statement on this issue reads:
To seek coherence between the spiritual and the material does not imply that the material goals of development are to be trivialized. It does require, however, the rejection of approaches to development which define it as the transfer to all societies of the ideological convictions, the social structures, the economic practices, the models of governance—in the final analysis, the very patterns of life—prevalent in certain highly industrialized regions of the world. When the material and spiritual dimensions of the life of a community are kept in mind and due attention is given to both scientific and spiritual knowledge, the tendency to reduce development to the mere consumption of goods and services and the naive use of technological packages is avoided. Scientific knowledge, to take but one simple example, helps the members of a community to analyse the physical and social implications of a given technological proposal—say, its environmental impact—and spiritual insight gives rise to moral imperatives that uphold social harmony and that ensure technology serves the common good. Together, these two sources of knowledge tap roots of motivation in individuals and communities, so essential in breaking free from the shelter of passivity, and enable them to uncover the traps of consumerism.
At present too many of us in so-called ‘developed’ societies, by which I mean ‘industrialised,’ are caught in the ‘traps of consumerism.’ The lemming mindset of the markets, hurling themselves confidently off the cliff’s edge convinced they’d find riches there, and the evidence I’ve recently seen in China of a huge nation becoming increasingly in thrall to the spell of possessing more and more material goods, do not suggest that we have yet got the balance right between prosperity and spirituality. And a lot hinges on our doing so, not just here but across the world as a whole, before it is too late.
In a later post I will be looking more closely at where I feel Kahneman’s admirable analysis breaks down. He is good at disentangling where our ways of thinking get us into trouble, he shows how we can improve, but he does not go by any means far enough, in my view, in explaining how we can best grow beyond our limitations in that respect. But that will have to wait.