Tuesday, January 5, 2016

The illusion of skill - II

Although professional investors are able to beat amateurs, Kahneman says that few, if any, have the skill to beat the market consistently. The logic for testing this is simple: if the rankings of the funds in any one year is entirely due to luck, then the year-to year correlation of their rankings should be zero. But if skill is involved, then the rankings will be more stable and therefore there will be year-to-year correlation, showing persistent achievement. This is similar to the rankings in any game, say tennis. If the rankings are random, then there will be no year-to-year correlation. But the top players are consistently ranked at the top so there will be year-to-year correlation of their rankings.

More than 50 years of research has shown that professional investors are playing a game of dice, not of skill. The year-to-year correlations are barely higher than zero. The traders think that they are making sensible, educated guesses but Kahneman says, 'In highly efficient markets, however, educated guesses are no more accurate than blind guesses.'

In Thinking, Fast and Slow, Kahneman relates a story of a speaking assignment that he had with a firm of investment advisers. He was given a spreadsheet having the investment data of 25 wealth advisers for 8 consecutive years which determined their year-end bonuses. He proceeded to calculate the correlation coefficients between the rankings in each pair of years giving a total of 28 correlation coefficients.If there was skill involved then there should be significant correlation between the year-to-year rankings of the advisers.

What Kahneman found was that the average of the 28 correlations was .01 which was statistically equivalent to zero. It meant that the wealth advisers were playing a game of chance, not of skill. No one in the firm including the advisers were aware of this reality. They all thought that they were doing a professional job. But even after being shown that the firm was rewarding luck not skill (a result that they couldn't deny because they had provided the data and could check the results) Kahneman was sure that it would be forgotten immediately.

He thinks that the key reason for the persistence of this illusion is because the traders are indeed using a type of skill. It requires a lot of hard work and training to be able to check economic forecasts , read P&L statements and balance sheets, study competition, etc. But is this skill enough to answer the key question: is all this information already incorporated into the stock price? Here traders switch to feelings and the data shows that it becomes a guessing game.It does not give one correct answer - except in retrospect, which is not very useful. But after all that hard work, traders become resistant to admitting this.

It is like what happens when I type. Sometimes, after typing a few sentences, I will feel that they are not quite fitting into the rest of the post. The logical thing to do would be to delete them. But after having spent all that time and effort in typing those sentences, I don't feel like seeing them disappear into the ether in less than a second. So I think of some excuse to retain them in the post and I generally succeed.

Kahneman adds:
If there is a discussion with Kahneman on CNBC, I would be a very interested listener,  although the chances of that happening are quite remote. You will not be happy if someone walks into the studio (an economics Nobel Prize winner at that) and says that the self-styled 'Masters of the Universe' are being paid because of their luck and not because of their skill. (But Kahneman seems a polite person so he may have some nice way of saying that they are fooling themselves.)

PS: Intuition - Marvels and Flaws. Daniel Kahneman, Nassim Taleb, Gillian Tett.

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