Monday, October 31, 2011

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.

7 comments:

Edward Ockham said...

This has been known for years, and is part of modern financial theory. Bachelier first proposed it (in his doctoral thesis) in the early 1900s). The idea was picked up in the 1960s and became the 'efficient market hypothesis'. It has three forms. Probably best to read the Wikipedia article on EMH, which is a reasonable introduction.

MKR said...

"Quakery"? Unless you mean to blame economic ills on the Society of Friends, I think you should correct your spelling.

Edward Ockham said...

That's not to say that no one can make money out of the market. What the EMH says is that any new information about the 'right' level of the market will quickly be picked up, usually by wholesale investors, and the market level will adjust accordingly. By the time the price reaches the person in the street, the retail investor, all the information has been 'discounted'.

Thus the market is 'random' to the end-user. This requires a definition of 'randomness' which relative to the information available. Given all the information we have about the FTSE today, i.e. excluding anything that might be future news, there is nothing there that allows us to predict the future direction of the market. What pushes the market is news, and news, by that definition, is random. (If we knew what the news was going to be, it wouldn't be news. A solar eclipse is not news. e.g.).

It's actually a very beautiful theory.

Stephen Law said...

oops yes. spelling checked.

Joseph Ward said...

great job! If income correlates so well with productivity, then how does society or a specific firm deal with lurking variables such as these?

Anonymous said...

Interesting article. For a more in-depth look at EMH and its relation to overconfident trading gusto, you should read the book Confidence Games, by Mark C. Taylor.

James Dunne said...

“Of all the ways of organising banking, the worst is the one we have today. ...eliminating fractional reserve banking explicitly recognizes that the pretence that risk-free deposits can be supported by risky assets is alchemy. To work, financial alchemy requires the implicit support of the tax payer...For a society to base its financial system on alchemy is a poor advertisement for its rationality.”
(Mervyn King, 2010, p17)

PositiveMoney.org.uk are an organisation worth looking at. They have serious proposals for monetary reform