Daniel Kahneman, Social Psychology, and Finance
'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?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.
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.
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.
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.
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.
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.