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Posted by on Oct 31, 2011 in Uncategorized | 1 comment

Economic quackery: the entirely illusory “skill” of the traders

A bit more on economic quackery. This is from an article published yesterday. The associated book by Kahneman looks very interesting. I previously noted this suspicious “skill”. It’s non-existent character is increasingly well-documented. But incredibly well rewarded!

Mutual funds are run by highly experienced and hardworking professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than 50 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. Typically at least two out of every three mutual funds underperform the overall market in any given year.

More important, the year-to-year correlation between the outcomes of mutual funds is very small, barely higher than zero. The successful funds in any given year are mostly lucky; they have a good roll of the dice. 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.

Some years ago I had an unusual opportunity to examine the illusion of financial skill up close. I had been invited to speak to a group of investment advisers in a firm that provided financial advice and other services to very wealthy clients. I asked for some data to prepare my presentation and was granted a small treasure: a spreadsheet summarising the investment outcomes of some 25 anonymous wealth advisers, for each of eight consecutive years. Each adviser’s score for each year was his (most of them were men) main determinant of his year-end bonus. 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 and whether the same advisers consistently achieved better returns for their clients year after year.

To answer the question, I computed correlation coefficients between the rankings in each pair of years: year 1 with year 2, year 1 with year 3, and so on up through year 7 with year 8. That yielded 28 correlation coefficients, one for each pair of years. 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. The consistent correlations that would indicate differences in skill were not to be found. The results resembled what you would expect from a dice-rolling contest, not a game of skill.

No one in the firm seemed to be aware of the nature of the game that its stock pickers were playing. The advisers themselves felt they were competent professionals doing a serious job, and their superiors agreed. On the evening before the seminar, Richard Thaler and I had dinner with some of the top executives of the firm, the people who decide on the size of bonuses.

We asked them to guess the year-to-year correlation in the rankings of individual advisers. They thought they knew what was coming and smiled as they said “not very high” or “performance certainly fluctuates”. It quickly became clear, however, that no one expected the average correlation to be zero.

Our message to the executives was that, at least when it came to building portfolios, the firm was rewarding luck as if it were skill. This should have been shocking news to them, but it was not. There was no sign they disbelieved us. How could they? After all, we had analysed their own results, and they were sophisticated enough to see the implications, which we politely refrained from spelling out. We all went on calmly with our dinner, and I have no doubt that both our findings and their implications were quickly swept under the rug and that life in the firm went on as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in their culture. Facts that challenge such basic assumptions – and thereby threaten people’s livelihood and self-esteem – are simply not absorbed. The mind does not digest them. This is particularly true of statistical studies of performance, which provide base-rate information that people generally ignore when it clashes with their personal impressions from experience.

The next morning, we reported the findings to the advisers, and their response was equally bland. Their own experience of exercising careful judgment on complex problems was far more compelling to them than an obscure statistical fact. When we were done, one of the executives with whom I had dined the previous evening drove me to the airport. He told me, with a trace of defensiveness: “I have done very well for the firm and no one can take that away from me.” I smiled and said nothing. But I thought: “Well, I took it away from you this morning. If your success was due mostly to chance, how much credit are you entitled to take for it?”

Cognitive illusions can be more stubborn than visual illusions. When my colleagues and I in the army learned that our leadership assessment tests had low validity, we accepted that fact intellectually, but it had no impact on either our feelings or our subsequent actions. The response we encountered in the financial firm was even more extreme. I am convinced that the message that Thaler and I delivered to both the executives and the portfolio managers was instantly put away in a dark corner of memory where it would cause no damage.

Why do investors, both amateur and professional, stubbornly believe that they can do better than the market, contrary to an economic theory that most of them accept, and contrary to what they could learn from a dispassionate evaluation of their personal experience? The most potent psychological cause of the illusion is certainly that the people who pick stocks are exercising high-level skills. They consult economic data and forecasts, they examine income statements and balance sheets, they evaluate the quality of top management, and they assess the competition. All this is serious work that requires extensive training. 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. Traders apparently lack the skill to answer this crucial question, but they appear to be ignorant of their ignorance.

1 Comment

  1. Several groups of men in several villages go out hunting and fishing over two decades. The hunters use traps, and the fishermen use spears. Each environment they hunt in has random distributions of prey in random locations, such as salmon jumping out of a river to be speared, and rabbits walking along a path of set traps etc. If you looked at the data from each hunter you could certainly infer the same assumptions about hunters as a whole, as those you have made about fund managers. (“They can’t predict the future”…my god, what revelations are at hand.) Does this mean the individual hunters’ skills are practically worthless? They wont be to him and his tribe, but they might be to someone looking for a correlation.

    Here is the gist of where “your ignorance about your ignorance” lies. Namely, you are stating the obvious and putting frilly knickers on it to boot. The fact of the matter is that, random or not, the job needs doing. You can offer no alternatives, given a lifetime you still wont because there aren’t any, and the fact that you hold up a method of correlation as evidence to negate the value of the day-to-day activities of individual fund managers is a dazzling display of your impotence as a “sceptic”. When you went into a group of economists and traders and asked them to swallow that correlation was causation, you were dealing with the wrong crowd, and thats most likely why you were dismissed.

    Would you walk into a tribe and confront the hunter that has provided the food for his family and declare he should not be appreciated, because according to math, he’s just very lucky? Rather they should make you chief you for pointing it out! You would love that wouldn’t you? They could all get fat on that.

    The fact is that the money needs managing, and the job requires the manager to go through cancer inducing stress on a daily basis with buckets of cortisol and adrenaline flushing through their system, that fact alone is enough for praise; they know about the burden of randomness, and its consequences. (You wouldn’t appreciate it though, as the only stress you suffer is through pondering your own existence). If the media, or colleagues want to give a guy a pat on the back for being right, so be it…do you really expect them to ignore his success because of a theoretical correlation with respect to the industry as a whole? Really? I mean, REALLY? Are you REALLY that naive? Can someone who lays claim to such ear splitting reason and hard-nosed logic really be so in the dark as to what makes the world turn? Its shocking! What next? Team mates cant congratulate a striker for scoring because no one could predict which way the defender was going to move?

    Why don’t you try managing a portfolio worth a year of your salary, and if you don’t succeed you don’t eat; see what it does to your constitution. I would be interested to hear about your coin flicking levels of scepticism after a year, and your level of serotonin for that mater.

    PS. You are measuring a managers skill as profit margin, while at the same time claiming that performance is as random as the market. This is the glaring contradiction fuelling your pontification, its probably also why your thoughts on the matter were dismissed. A managers skill lies in how he deals with both random bad and good situations, regardless of their frequency; a good manager can manage countless bad situations extremely well for long periods of time, and of course lose money or break even,take it on the chin and keep going. On the other hand a poor manager can handle good situations poorly and lose even more money, have a heart attack, lose all his hair and retire.

    Hence you would need to gauge how each each individual manager behaved in a time of crisis as well as times of easy sailing, whether or not that behaviour was optimal within a set of constraints, and develop a method of determining if the behaviour was consistent. You could then come back and deduce from your data that most managers might have been handling bad random situations relatively well? Of course not, where is the mischief in that?

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