I’ve been a booster of the Tversky-Kahneman cognitive-bias revolution since I read their article in Scientific American as a high school student. (To be honest, I’d always lazily thought of it as Tversky’s work, but Daniel Kahneman has had the good sense not to die prematurely, and to collect a Nobel memorial prize.) And I’ve greatly enjoyed Kahneman’s new popular book on his collected lessons from many decades of research on cognitive biases.
Putting that together with my longstanding contempt for the finance profession (expressed at greatest length here, but more generally listed here), I was particularly delighted to start in on the chapter titled “The Illusion of Validity”, where Kahneman lays into the self-serving illusions of finance professionals. It turns out, though, that this chapter is an intellectual trainwreck, with oversimplifications piling up on crude distortions, while the whistle of self-satisfied self-promotion shrills incessantly in the background. It’s both insufferable and so poorly reasoned that it begins to call the reliability of the rest of the book into question. Kahneman doesn’t claim to be free of the cognitive biases he analyses in others, but you might expect more self-awareness.
The first part of the chapter tells a story that I’ve read before, and have found quite illuminating, about the yawning gap between the failure of his Israeli Defence Force psychology team, lo many years ago, to predict the future success of officer candidates on the basis of observing them in a test, and their illusory confidence in their predictions. But then he applies this “lesson” to “The illusion of stock-picking skill”. He and two colleagues visited a senior investment manager 30 years ago to discuss the role of judgement biases in investing.
‘When you sell a stock,’ I asked, ‘who buys it?’ He answered with a wave in the vague direction of the window, indicating that he expected the buyer to be someone very much like him. That was odd: What made one person buy and the other sell? What did the sellers think they knew that the buyers did not?
Since then, my question about the stock market have hardened into a larger puzzle: a major industry appears to be built largely on an illusion of skill. Billions of shares are traded every day, with many people buying each sock and others selling it to them… Most of the buyers and sellers know that they have the same information: they exchange the stocks primarily because they have different opinions. The buyers think the price is too low and likely to rise, while the sellers think the price is high and likely to drop. The puzzle is why buyers and sellers alike think that the current price is wrong. What makes them believe they know more about what the price should be than the market does? For most of them, that belief is an illusion.
Now, I don’t mean to cast doubt on the basic assertion that most investment professionals are delusional, and purely as a matter of belief I would affirm the creed that international finance is in the hands of dangerous lunatics.* But as a matter of logic, the mere fact that proposition D (financiers are delusional) is true, does not imply that every syllogism that has D as a conclusion is valid. Most truths are (in Kantian language) synthetic truths: One could imagine a financial sector that was not a lunatic asylum, it just happens empirically not to be the one we have. Most simple demonstrations of why other people are obviously stupid are wrong. I suppose it’s understandable that someone like Kahneman, who has indeed had the experience of establishing simple truths that a large number of smart people had failed to notice, might be inclined to discount the warning signs that other people may understand something in a more complex way than he does.
Kahneman’s argument here was anticipated, in a different context, by the great thinker Douglas Adams, in The Hitchhiker’s Guide to the Galaxy:
Bypasses are devices that allow some people to dash from point A to point B very fast while other people dash from point B to point A very fast. People living at point C, being a point directly in between, are often given to wonder what’s so great about point A that so many people from point B are so keen to get there, and what’s so great about point B that so many people from point A are so keen to get there. They often wish that people would just once and for all work out where the hell they wanted to be.
It’s about as cogent as Kahneman’s argument, but Adams’s version is demonstrably funnier. If Kahneman had written The Hitchhiker’s Guide, he would have written,
Commuters travel billions of miles every day, with some people going east and others going west… Most of the commuters know that they have the same information: they travel primarily because they have different opinions. The commuters from the east think it’s better to be in the west in the morning, and the commuters from the west think it’s better to be in the east; and in the evening they reverse their opinions. The puzzle is why both groups think that their current location is wrong. For most of them, that belief is an illusion.
Now, at any given time there are some people travelling to a new location that they consider to be superior in some absolute sense, and they may very well wonder why some other people don’t recognise that superiority and desert the inferior location. (In fact, Kahneman discusses elsewhere the mistaken but widespread belief that people in California are generally happier, what with their daily doses of sunshine, than the accursed midwesterners.) But most commuters and travellers, and probably even many migrants, recognise that they are not climbing some gradient of geographic quality, but going someplace that is better for them at this time.
Now, again, it may be an empirical fact that some large percentage of equity traders think they can recognise a stock that’s about to rise, on the basis of no special expertise, and buy it cheap from someone less insightful. But it’s not the kind of truth that you can establish on the basis of a five-line sneer. Most investment professionals are not picking individual stocks, but are assembling portfolios. Suppose I own many shares of AAA US subprime mortgage-backed securities and lots of oil futures. You own wheat futures and shares of Dystopian Ammunition and Survival Supplies. In the state of the world where (hypothetically) people like us manage to engineer a collapse of the world economy, the US housing market and oil prices are going to plummet simultaneously, while wheat and ammunition are both going to seem like pretty good things to be holding. So swapping the oil futures for the wheat futures could make us both better off, by reducing our risk.
Again, I’m not casting doubt on the empirical fact that most investment professionals are providing negative value to their marks clients; only pointing out that this is a synthetic truth, not analytic as Kahneman seems to believe. (It is, on the other hand, something like a synthetic truth that an average investor would be better off investing in a market average than with an active investor, simply because of the mathematical fact that the market average gives the average of all investors’ performance, QED. See here for further discussion. But this is a different point than the one that Kahneman is making.) As John von Neumann wrote to Stanislaw Ulam in 1939,
I refuse to accept however, the stupidity of the Stock Exchange boys, as an explanation of the trend of stocks. Those boys are stupid alright, but there must be an explanation of what happens, which makes no use of this fact.
Actually, his reasoning goes off the rails elsewhere in the same chapter, also in the context of business. Here he laments the inability of otherwise intelligent people to appreciate the role of luck in success, which I would guess to be basically a true observation. He was invited to speak to a group of investment advisers that served “very wealthy clients”. He ranked the different advisers in each year, and computed the correlation coefficients between the rankings in different years. His argument was that skill would be demonstrated through a correlation between performance in different years, and when he discovers that the average correlation was essentially 0, he concludes that investing is simply a game of chance.
The logic is simple: if individual differences in any one year are due entirely to luck, the ranking of investors and funds will vary erratically and the year-to-year correlation will be zero. Where there is skill, however, the rankings will be more stable. The persistence of individual differences is the measure by which we confirm the existence of skill among golfers, car salespeople, orthodontists, or speedy toll collectors on the turnpike.
Let’s consider an analogous situation: A hospital has five general surgeons on staff. DK ranks them each year according to the survival rate of their patients for coronary bypass surgery, and discovers that there is no correlation between a surgeon’s rankings in different years. Over 10 years the rankings look to be completely random. DK concludes that there is no skill involved in coronary bypass surgery. Someone less brilliant than DK might conclude, instead, that the surgeons are all equally skillful.
There are two fallacies at work here: A false reversal of implication, and neglect of the comparison group. Certainly, lack of correlation isconsistent with investing being a game of chance, but it does not imply it. We would quickly recognise the skill required for coronary bypass surgery if we compared the professionals not with their colleagues, but with a control group randomly selected from the same town. Now, it may be that the variability of skill among surgeons is sufficiently great that you would inevitably recognise differences in performance among five of them. But it could be that this procedure is sufficiently routine and undemanding (consider, perhaps, appendectomies instead), that there is a broad plateau of skill: You need a trained professional, but almost any professional will do about the same job. Indeed, Kahneman had just finished presenting convincing evidence that the vast majority of amateur investors blunder in predictable ways, losing vast sums of money to the broad class of professional investors. So clearly some skill must be involved in professionals distinguishing themselves consistently from the amateurs, whether or not this shows up as consistent differences among the professionals. (There could be some assortative mating going on here: Within a firm there will be investors of approximately the same skill level. Those who are better than the others seek out a higher quality firm, so they won’t be associated with a bunch of losers. And those who are below average get pushed out.)
That’s not how Kahneman sees it. He scoffs at the failure of others to accept his absolute rightness:
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 I had dined with 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?”
I suppose it can be seen as instructive, that someone who has spent most of his life thinking about chance, and how people misunderstand it, should himself be so self-righteously confused on simple matters of inference concerning chance.
Otherwise, the book is hugely insightful, and a delight to read…
* His partner in self-love, Nassim Taleb (and mutual admirer: Taleb is cited repeatedly in this book for his remarkable insights, and has reciprocated with a fawning paragraph on the book jacket), has maintained, on the basis of extensive experience (and what seems to be genuine understanding of the issues involved), that the vast majority of traders are deluded by the illusion of their own skill, ignoring the role of luck in their success.