Kahneman Fathoms the Human Mind

I always enjoy the thoughts of Daniel Kahneman even if I don’t entirely agree with everything he says. Then again, I might just be one of those quacks he refers to who has convinced himself that he’s an expert in something that no one is really an expert in….

Via Forbes:

Forbes: You won a Nobel Prize for fathoming the human mind. You’ve made the point that perhaps because there are so many smart people in finance, that individual stock pickers, managers, cannot consistently beat the market.

Kahneman: Well, it’s not a point I made. The point, I’m not a finance expert, so you know.

Forbes: Well, clearly, they’re not either.

Kahneman: Well, when it comes to stock picking perhaps nobody is. That certainly was [Burton] Malkiel’s (PH) point. So, I am the consumer of this stuff. But what I find very interesting is that although everybody, I think, recognizes that in principle, you can’t do this. Because if you could pick stocks very well, then other people would also be picking those stocks, so the advantage would be gone. So everybody realizes that in principle, it’s impossible. But everybody personally thinks they can do it.

Kahneman: Yeah. And that’s exactly like the officer story. That, I find fascinating. I call it an illusion of skill. You know that it’s wrong, but you feel something else.

Forbes: And why does that persist?

Kahneman: It persists because you get the immediate feeling that you understand something. That is much more compelling than the knowledge of statistics that tell you that you don’t know anything. And, that again, is the officer story. But it’s writ large, that you really see it at work in many domains. In the financial domain, where people feel that they can do things that, in fact, we know and they should know they can’t do.



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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. I disagree, in the sense that he is assuming that all the smart people are a) making rational decisions, and b) all are working from the same understanding.
    If anything the past 10 years have shown us, is that investment managers are not rational. Some would even say that fundamentals don’t matter.
    And readers of this blog would say that they have a different understanding of the financial system which gives them an inside edge on investing decisions.

  2. Investment managers are rational in the sense that they act out of their own self interest, which is to keep their jobs.

  3. They should just come out of the closet :)

    Seriously, it’s actually much less stressful.

  4. You wouldn’t want anyone to know that you’re running an index fund for 1% more than Vanguard does it. After all, if they found out you’d lose all your AUM. Now THAT would be stressful. :-)

  5. ” I might just be one of those quacks he refers to who has convinced himself that he’s an expert in something that no one is really an expert in…”

    Charter member here…

  6. You can’t legally have more information than the market. That is, if, for instance, you think you can do a better job predicting company X’s earnings in the coming years than the market, you are wrong. The crowd is consistently wiser with these sorts of questions in the same way that averaging everyone’s guesses for how many jellybeans are in a jar will always beat 99% of the individual guesses (and the 1% that are better are just lucky and can’t repeat their luck).

    But the wisdom of crowds doesn’t mean the market can’t be beaten with skill (as opposed to luck). Basically, every once in a while, the collective wisdom of the stock market will break down (perhaps a handful of times in a career – think of Warren Buffett’s “punch card” or Jeremy Grantham’s “career units”). This will be due to group-think, or individual investors no longer thinking and acting independently (essential for the crowd to be wise). What causes this group-think? Usually some kind of disruption – a new technology, a rising economic power (Japan, China), etc. The disruption is real, but eventually everyone gets too excited and makes unrealistic linear projections. This creates opportunities to diverge from the crowd and make long term alpha. But you better get the timing right (or be the boss or managing your own money) or you’re likely to lose your job…it’s painful to sit on the sidelines in a hot market.

    But generally, you have to look where people are no longer thinking independently, but instead just relying on the conventional wisdom. I don’t think this is something that can be quantified though – it’s more art than science.

  7. Most of the discussion around the area of beating markets focuses around stock picking , when we all know that there number of different types of participants which do not care about stocks and even within equity markets they don’t care about stock picking. Granted that the value of superior knowledge will diminish as the knowledge becomes successful, which happens in case of stock picking. But making money is function of many things one can get superior understanding of a phenomenon other can get in a trade earlier than others so on and so froth.

  8. The people who are good at this know that they can’t know. The rest search for the Holy Grail. It’s not about knowing but instead about managing money, keeping losses lower than profits. Look for trades that offer a realistic place to put a tight stop (as opposed to unrealistically tight stops that nearly guarantee a loss) and offer an unobstructed run to a worthwhile resistance point. Look for patterns that increase your odds. Mostly it’s just toiling away looking at charts, if it never gets boring you’re probably doing something wrong. At least that’s how I do it.

  9. I don’t spend much time looking at charts at all, and yet I still trade a lot. No wonder I’m not an expert at it. I’ve been looking for the guru who knows how to time the markets and how to select stocks or sectors. Unfortunately, no one out there can do it consistently. Does not stop a whole lot of us from trying.

  10. Larry, check out Peter L Brandt. He is possibly the best technical analyst in the world today and there is plenty of free stuff on his site. Start with the newer posts and keep going, even the out of date stuff will teach you a lot. Claims 40% returns, I haven’t checked it out but I don’t think he has to lie. Trades mostly commodities but principles easily transfer to stocks. FWIW “market timing” really isn’t the focus, timing comes from doing it right, almost a by-product. TA is more about recognizing habits in human behavior and statistics. As long as you’re quick to recognize a bad trade and take a good stop, being right 1/3 of the time should make money. Tons of good, free knowledge out there.

  11. @Michael,

    Thanks for sharing info about Peter L. Brandt. Will look into this.

  12. Mr. Roche,

    I’d like to bring to your attention Maurice Allais ( French Economist and 1988 Noble prize winner- as if that’s any indication of how good their contributions are) whose discoveries and research in Economics, Monetary policy, Markets & behavioral economics provide profound insights-long before his theories & observations are rediscovered or popularized in English by notable economists. He provided a detailed analysis of the limitations & pitfalls of expected utility theory, that Mr. Kahneman espouses.