Zack Shepard's blogSanity

The Entire Investment Profession Is Built On An Illusion Of Skill

Money managers across the globe had better take a contract out on Daniel Kahneman, a Princeton Professor of Psychology, who won the Nobel Prize in Economic Sciences for pioneering work with the late Amos Tversky on decision making.

One revolutionary thrust of Kahneman ‘s new bestseller, “Thinking, Fast and Slow”– is that all the predictions by analysts, economists, corporate CEOs and cable tv talking heads about the stock market in 2012 are pure unadulterated guesswork and beliefs that are in effect an illusion of the future they project.  So much for George Soros and Warren Buffett and Bill Gross and Larry Fink and Byron Wien, and all the other highly paid and acclaimed soothsayers of  the markets. Think how few of them got the markets right. Gross predicted inflation would wrack the bond market.  Soros a gold bubble, Buffett a much healthier economy. I’m told hardly anyone got 2011 to any meaningful extent correctly.

For Kahneman has decided that ” 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 stock and others selling it to them… The puzzle is why buyers and sellers alike think that the current price is wrong… For most of them, that belief is an illusion.”

Wow!. This seems to go further than Burton Malkiel’s ” A Random Walk Down Wall Street.” It seems to suggest that there is no such thing as “smart money.” It is really only “lucky money.” After all at least 2 of every 3 mutual funds underperform the overall market in any given year. I can tell you the most I’ve made on Power Ball is $3.00. I’m still looking for that killing. Pure unadulterated luck required.

I guess the whole idea of ” a black swan” like the meltdown in mortgage backed bonds t hat kicked off in 2007 and ran markets everywhere ragged in 2008– was not an inevitable event that could have been predicted, except maybe by NYU economist Nouriel Roubini, who definitely predicted disaster and the course it would take.

Kahneman agrees that some people “ thought well in Advance that there would be a crisis, but they did not know it.” Kahneman insists that you can’t really “know” something is going to happen “if it is both true and knowable.” Kahneman pours cold water on the idea of prescience, calling it undeserved. So,  at minimum you had better stop spending useless money consulting a fortune teller, or asking your Uncle Sid about his latest hot stock.

He  suggests the prognosticators  did not conclusively believe ” a catastrophe was imminent.” Kahneman puts down the notion of intuition and premonition; this language does not mean we can think clearly enough about the past to predict the future.

Luck, chance, randomness play a much more powerful role than we ever thought possible. You should be getting very anxious right at this point. You mean my investment icon, Warren Buffett, is just lucky? Maybe the stocks he buys go up because he buys them– not because they are of superior profitability and management skills.

Certainty of our judgement is then illusory.  Kahneman writes of “ The Halo Effect,” a book by Philip Rosenzweig, which shows that writers(not investors) “exaggerate the impact of leadership and management in providing CEOs with the “halo effect,” they may not really deserve.

A study of Fortune’s Most Admired Companies found over a 20 year period that “the firms with t he worst ratings went on to earn much higher stock returns than t he most admired firms.” What a punch in the soilar plexus t hat was.

“Considering how little we know, the confidence we have in our beliefs is preposterous– and it is also essential,” writes Kahneman at t he top of a chapter on “The Illusion of Validity.” Ouch! I’ve been all t his time just using my own personal “illusions of validity.”

(Source: forbes.com)

Gambler or Investor? The Truth About Why We Trade

It is a well-worn cliche. The stock market is the capitalist casino, a place where gambling wears a thin mask called investing.

It is a place where “buy gold” or “buy Pandora” can sound a lot like “come on, seven!”

The idea, of course, is that we so-called investors aren’t actually putting our money to work. We are engaging in a socially acceptable version of the lotto. We are betting the odds. Like a player at the craps table, we are trying to get hot—riding the momentum of a bull market, pulling back when the wheel of fortune goes cold.

And, just as anyone who goes to Las Vegas knows that the house usually wins, investors know that trading can be a cruel game.

There is some truth to that analysis, of course. But is it the whole truth? Is Warren Buffett simply playing a more respectable version of Texas hold ‘em? Is John Paulson counting mortgages like card counter in a game of single-deck blackjack?

The answer to a large degree depends on whom you ask. Investors, academics, gambling addicts and psychologists all have their own take. Neurologists have their own observations about pleasure centers in the brain. A common thread runs through the different opinions: We get in trouble when we trade for thrills.

“In gambling, the act is done for the love or ‘thrill’ of it,” said Prakesh Deeriya, a finance professor at the University of North Texas.

In that way, the thrill of gambling differs from trading, Mr. Deeriya said , because “the ‘thrill’ itself is the reward. In speculation, the return on investments is the reward, or at least the expectation of getting a return is the reward.”

The distinction changes, he said, when a trader gets the thrill from pushing the button, when the high comes from playing the game, rather from winning it. “If it is there,” he said, “then one can say that is gambling.”

Not surprisingly, investors have a different take depending on their discipline. Elie Rosenberg, who runs the ValueSlant.com blog is a value investor. He sees the distinction between gambling and investing as a distinction between buy-and-hold investing and speculation.

Mr. Rosenberg quotes American economist Ben Graham, who argued that “investment is most successful when it is most businesslike. An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return.”

Anything else, Mr. Rosenberg says, is probably gambling.

Gambling addicts would probably agree. A Gamblers Anonymous member told me that investing is a common topic in the group’s discussions. Some members share stories about how obsessive trading disrupts lives and leads to financial and personal ruin.

The group has a general rule that members should hold a stock for at least 18 months—if they invest in stocks at all. Commodities and options trading seem to be a particular problem.

The link between gambling and trading isn’t just a personal one, said Steven Weisman, a professor who teaches entertainment and gambling law at Bentley University in Boston. Recent Internet gambling laws have excluded day trading which, he said, “is as much of a gamble as any throw of the dice or bet on a horse.”

Mr. Weisman seems to agree that long-term investing is different from speculative trading, which is more akin to gambling. He notes that the brokerage firm Cantor Fitzgerald launched a mobile gaming device for casino use that piggybacks on technology developed for the markets.

Sometimes, the line between investing and gambling can be hard to see. Tony Emerson, an investor and gambler in Austin, Texas, said that what starts out as research-driven investing can turn into a blind gamble quickly.

“Consumer sentiment is impossible to predict,” Mr. Emerson said. “Models and analyses that once seemed to work to predict stock movement failed when the economy crashed.”

Still, it doesn’t take a market collapse for the similarities to show themselves.

“The losses and gains are generally less dramatic than craps, blackjack, roulette or poker. But just like gambling, the more you risk, the more you stand to gain,” Mr. Emerson said.

The real problem, according to Todd Tresidder, a former hedge-fund manager who is now a financial coach, is that most people don’t understand the odds. He argues what sounds like card-counting the markets: knowing the math takes gambling out of the equation.

“If you invest like most people, there is no difference,” Mr. Tresidder said. Investors, he argues, understand the odds. “The only way you will profit over time is either by sheer luck or by betting on positive mathematical expectancy situations,” he said.

Mr. Tresidder has a point about knowing the odds, but don’t a lot of gamblers know the odds? They pull the trigger, make the wager, or trade anyway. It is the thrill of betting that they love.

Maggie Baker, a clinical psychologist in Philadelphia, said that the neurological similarities between traders and gamblers are striking. Whether they are about to make a trade or plunking down a bet, the pleasure center in the brain lights up, Ms. Baker said.

It says: “Oh, boy, I’m going to do something that’s going to make me money.”

It isn’t too different from the anticipation for sex, Ms. Baker added. “In some ways, it’s better to hope than get,” she said.

Of course, this kind of stimulation can be dangerous. And that is why Ms. Baker said it is important to be mindful of two major factors in our control: environment and motivation. A trading floor isn’t that much different from a floor of a casino in that regard. There is a lot of social support for addictive behavior.

And what are our motives? Are we trying to impress people? Empower ourselves? Is it tied to our self-esteem?

Ultimately, the difference between healthy investing and gambling comes back to the thrill. When that becomes the sole purpose of buying and selling securities, investors have crossed the line. They are gamblers.

They will be until the thrill and, likely the money, is gone.

(From June 16th article in Wall Street Journal by David Weidner)

(Source: The Wall Street Journal)