The Illusion of Skill

This article is adapted from the book "Thinking, Fast and Slow" by Professor Daniel Kahneman that was published last year. The Princeton professor is known for research on how quirks in human behavior lead to illogical decision-making and outcomes.

In the 2nd half of the article, Professor Kahneman focuses on results from studies of active traders, professional fund managers, and wealth advisers.

Active Traders, Take a Nap
According to the article, an analysis of trading records by Professor Terrance Odean* revealed that individual investors lose consistently by actively trading:

On average, the shares investors sold did better than those they bought, by a very substantial margin: 3.3 percentage points per year...

This doesn't include the not insignificant costs of trading. The article later added:

...the large majority of individual investors would have done better by taking a nap rather than by acting on their ideas.

I've covered this "illusion of control" in a prior post:

The Illusion of Control

Later in the article, Professor Kahneman examines a somewhat different illusion but, before looking at that, here's some more evidence from the article that less activity produces superior results.**

Odean and his colleague Brad Barber showed that, on average, the most active traders had the poorest results, while those who traded the least earned the highest returns.

The Illusion of Skill
While professional investors and traders may have (or at least would be expected to  have) the skill needed to outperform the market compared to amateurs, the evidence from 50 plus years of research suggests:

...for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. At least two out of every three mutual funds underperform the overall market in any given year.

Now, what about wealth advisors? Kahneman looked at data for some anonymous wealth advisers to figure out whether the same advisers consistently achieved better returns for clients and display more skill than others. Once again...

The results resembled what you would expect from a dice-rolling contest, not a game of skill.

So what was the response from the directors when they heard of the findings? Kahneman says he and Richard Thaler told the directors the following:

What we told the directors of the firm 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 that they disbelieved us. How could they? After all, we had analyzed their own results, and they were certainly sophisticated enough to appreciate their implications, which we politely refrained from spelling out.

Then later Kahneman added:

...I am quite sure that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry. Facts that challenge such basic assumptions — and thereby threaten people's livelihood and self-esteem — are simply not absorbed.

Not surprisingly, when they reported the finding to the wealth advisers themselves the response was similar. Kahneman closed with the following:

...overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.

In the 1970s, the work of Kahneman (in collaboration with Amos Tversky) challenged the flawed but once prevailing wisdom in social science that people generally acted rationally and selfishly (in some ways still alive and well even if to a lesser extent). First, they showed that mental shortcuts (heuristics) are useful but "lead to severe and systematic errors." Experiments they did revealed "cognitive biases" or unconscious errors of reasoning. Later, their prospect theory exposed flaws in the dominant models in economics at the time. The basic assumption that people will always act rationally and in their own interests was wrong.

For Kahneman and Tversky, it was obvious that people are not fully rational nor selfish.

In 2002, Kahneman won the Nobel in economic science. What's at least notable about winning such an award is that Kahneman is a psychologist.

I am currently reading Kahneman's "Thinking, Fast and Slow". The book looks at the many forms of cognitive bias and at the flawed manner that traditional economic models assume people behave (among many other things). I've found it insightful and useful for investing and beyond. It is a comprehensive (and, though accessible, I mean comprehensive!) look at the sources of human irrationality.

To me, Kahneman seems most interested in allowing the implications of the better ideas in his field to speak for themselves, while recognizing their limitations, and noting some of the key disagreements among colleagues, where applicable.

To me, it's a refreshingly humble approach.

The book has been well worth reading so far.


Related posts:
The Illusion of Control
Charlie Munger on LTCM & Overconfidence
When Genius Failed...Again

* Terrance Odean is the Professor of Finance at the University of California, Berkeley.
** Based upon Terrance Odean's and Brad Barber's paper: "Trading Is Hazardous To Your Wealth".
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The Illusion of Skill
The Illusion of Skill
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