From Brennan;
I’ve been wanting to invest but have no idea how to get into it without completely losing out on a company.
So, lets think about this….
Technology has advanced beyond the reach of main street investors. Today the market is at best a crap shoot, and at worst… many think; ‘a rigged game’. In any event it’s a market manipulated by faulty confidence. Best to avoid.
But let’s first consider…
Because of confidence by coherence, the subjective confidence we have in our opinions reflects the coherence of the story that we have constructed. The amount of evidence and its quality do not count for much, because poor evidence can make a very good story. For some of our most important beliefs we have no evidence at all, except that people we trust hold these beliefs. Considering how little we know, the confidence we have in our beliefs is preposterous—and it is also essential.
Subjective confidence in a judgment is not a reasoned evaluation of the probability that this judgment is correct. Confidence is a feeling, which reflects the coherence of the information and the cognitive ease of processing it. It is wise to take admissions of uncertainty seriously, but declarations of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily that the story is true.
The Stock Market; a major industry appears to be built largely on an illusion of skill.
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.
If all assets in a market are correctly priced, no one can expect either to gain or to lose by trading. Perfect prices leave no scope for cleverness, but they also protect fools from their own folly. The diagnostic for the existence of any skill is the consistency of individual differences in achievement.
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. 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.
Cognitive illusions can be more stubborn than visual illusions.
Finally, the illusions of validity and skill are supported by a powerful professional culture. We know that people can maintain an unshakable faith in any proposition, however absurd, when they are sustained by a community of like-minded believers. Given the professional culture of the financial community, it is not surprising that large numbers of individuals in that world believe themselves to be among the chosen few who can do what they believe others cannot.
The Illusions of Pundits
The idea that the future is unpredictable is undermined every day by the ease with which the past is explained. As Nassim Taleb pointed out in The Black Swan, our tendency to construct and believe coherent narratives of the past makes it difficult for us to accept the limits of our forecasting ability. Everything makes sense in hindsight, a fact that financial pundits exploit every evening as they offer convincing accounts of the day’s events. And we cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday. The illusion that we understand the past fosters overconfidence in our ability to predict the future.
The often-used image of the “march of history” implies order and direction. Marches, unlike strolls or walks, are not random. We think that we should be able to explain the past by focusing on either large social movements and cultural and technological developments or the intentions and abilities of a few great men. The idea that large historical events are determined by luck is profoundly shocking, although it is demonstrably true. It is hard to think of the history of the twentieth century, including its large social movements, without bringing in the role of Hitler, Stalin, and Mao Zedong. But there was a moment in time, just before an egg was fertilized, when there was a fifty-fifty chance that the embryo that became Hitler could have been a female. Compounding the three events, there was a probability of one-eighth of a twentieth century without any of the three great villains and it is impossible to argue that history would have been roughly the same in their absence. The fertilization of these three eggs had momentous consequences, and it makes a joke of the idea that long-term developments are predictable.
Yet the illusion of valid prediction remains intact, a fact that is exploited by people whose business is prediction—not only financial experts but pundits in business and politics, too. Television and radio stations and newspapers have their panels of experts whose job it is to comment on the recent past and foretell the future. Viewers and readers have the impression that they are receiving information that is somehow privileged, or at least extremely insightful. And there is no doubt that the pundits and their promoters genuinely believe they are offering such information. Philip Tetlock, a psychologist at the University of Pennsylvania, explained these so-called expert predictions in a landmark twenty-year study, which he published in his 2005 book Expert Political Judgment: How Good Is It? How Can We Know? Tetlock has set the terms for any future discussion of this topic.
Tetlock interviewed 284 people who made their living “commenting or offering advice on political and economic trends.” He asked them to assess the probabilities that certain events would occur in the not too distant future, both in areas of the world in which they specialized and in regions about which they had less knowledge. Would Gorbachev be ousted in a coup? Would the United States go to war in the Persian Gulf? Which country would become the next big emerging market? In all, Tetlock gathered more than 80,000 predictions. He also asked the experts how they reached their conclusions, how they reacted when proved wrong, and how they evaluated evidence that did not support their positions. Respondents were asked to rate the probabilities of three alternative outcomes in every case: the persistence of the status quo, more of something such as political freedom or economic growth, or less of that thing.
The results were devastating. The experts performed worse than they would have if they had simply assigned equal probabilities to each of the three potential outcomes. In other words, 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 non-specialists.
Those who know more forecast very slightly better than those who know less. But those with the most knowledge are often less reliable. The reason is that the person who acquires more knowledge develops an enhanced illusion of her skill and becomes unrealistically overconfident. “We reach the point of diminishing marginal predictive returns for knowledge disconcertingly quickly,” Tetlock writes. “In this age of academic hyper-specialization, 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.” The more famous the forecaster, Tetlock discovered, the more flamboyant the forecasts. “Experts in demand,” he writes, “were more overconfident than their colleagues who eked out existences far from the limelight.”
Tetlock also found that experts resisted admitting that they had been wrong, and when they were compelled to admit error, they had a large collection of excuses: they had been wrong only in their timing, an unforeseeable event had intervened, or they had been wrong but for the right reasons. Experts are just human in the end. They are dazzled by their own brilliance and hate to be wrong. Experts are led astray not by what they believe, but by how they think, says Tetlock. He uses the terminology from Isaiah Berlin’s essay on Tolstoy, “The Hedgehog and the Fox.” Hedgehogs “know one big thing” and have a theory about the world; they account for particular events within a coherent framework, bristle with impatience toward those who don’t see things their way, and are confident in their forecasts. They are also especially reluctant to admit error. For hedgehogs, a failed prediction is almost always “off only on timing” or “very nearly right.” They are opinionated and clear, which is exactly what television producers love to see on programs. Two hedgehogs on different sides of an issue, each attacking the idiotic ideas of the adversary, make for a good show.
Foxes, by contrast, are complex thinkers. They don’t believe that one big thing drives the march of history (for example, they are unlikely to accept the view that Ronald Reagan single-handedly ended the cold war by standing tall against the Soviet Union). Instead the Foxes recognize that reality emerges from the interactions of many different agents and forces, including blind luck, often producing large and unpredictable outcomes. It was the Foxes who scored best in Tetlock’s study, although their performance was still very poor. They are less likely than hedgehogs to be invited to participate in television debates.
It is Not the Experts’ Fault—The World is Difficult
The point here, is not that people who attempt to predict the future make many errors; that goes without saying. 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).
Short-term trends can be forecast, and behavior and achievements can be predicted with fair accuracy from previous behaviors and achievements. But we should not expect performance in officer training and in combat to be predictable from behavior on an obstacle field— behavior both on the test and in the real world is determined by many factors that are specific to the particular situation. Remove one highly assertive member from a group of eight candidates and everyone else’s personalities will appear to change. Let a sniper’s bullet move by a few centimeters and the performance of an officer will be transformed. I do not deny the validity of all tests—if a test predicts an important outcome with a validity of .20 or .30, the test should be used. But you should not expect more. You should expect little or nothing from Wall Street stock pickers who hope to be more accurate than the market in predicting the future of prices. And you should not expect much from pundits making long-term forecasts—although they may have valuable insights into the near future. The line that separates the possibly predictable future from the unpredictable distant future is yet to be drawn.
Just for thought…
– The best-performing 4% of listed stocks accounted for the entire lifetime dollar wealth creation of the U.S. stock market since 1926.
– Only 42.1% of all the stock returns (both monthly and for as long as a stock was listed) were even positive; by definition, the one-month T-Bill rate was always positive.
– Less than half (specifically 47.7%) of one-month stock returns were greater than the T-Bill returns for the same month.
– The reason that overall long-term positive stock returns seem so high is statistical: A stock (think Apple, Google, Microsoft) can appreciate by many thousands of percentage points, while a loser like Enron or Washington Mutual can lose only 100%.
So while the stock market DJIA, created about $32 trillion in lifetime wealth over this approximately 90 years, more than half of that came from only 86 top-performing stocks (out of nearly 26,000).
