It's often said that people misperceive skill and luck, for example by saying that a team is on form when it has merely had a run of good fortune. A new experiment at the Autonomous University of Barcelona shows that this error is even worse than we thought.

Jordi Brandts and colleagues got a group of students to predict a sequence of five coin tosses, and then selected the best and the worst predictor. They then asked other subjects to bet on whether the best and worst predictor could predict another five coin tosses. The subjects were told that they would bet on the worst predictor from the first round, unless they paid to switch to the best predictor.

82% of subjects paid to make the switch.

But of course, there is no such thing as an ability to predict the toss of a coin. Most subjects, then, saw skill where there was only luck. And, what's more, they were willing to spend good money to back this daft opinion.

These people weren't just idiots plucked from the street. They were fourth year finance undergraduates at one of the best universities in Spain.

Now, a common complaint about laboratory economic experiments is that they lack external validity; what's true of small stakes experiments with students might not apply to the real world. But I'm not sure this concern applies in this case.

For one thing, this result corroborates Powdthavee and Riyanto's work, which has found subjects in Thailand and Singapore willing to pay for the non-existent ability to "predict" the toss of a coin.

And for another thing, there is a vast industry which owes its existence to people believing there is skill where there is (for the most part) only luck. I refer of course to the fund management industry. There's good evidence that actively managed funds generally do badly; for example, in the last five years most UK all company unit trusts have under-performed a decent tracker fund. Despite this, investors spend billions on fees for such managers. This is consistent with the experimental evidence showing that people see skill where none actually exists.

Now, you might object here that if people lose money by buying stupid they'll eventually wise up. Such a view relies upon a silly Econ 101 misunderstanding of how markets work. We know from the work of people such as Andrei Shleifer (pdf), Bernard Dumas and Bjorn-Christopher Witte that financial markets do not necessarily select against the stupid and in favour of the smart. And we also know - from the long history of quack medicines (pdf) in the US - that the demand for bad products can be inelastic with respect to failure.

Read the original article on Stumbling And Mumbling. Copyright 2013.