by Elliott Morss
Daniel Kahneman just wrote an interesting article on certain groups ignoring the outcomes of their recommendations. One case involved an evaluation of candidates for officer training. In another, Kahneman reported on the performance of investment advisers. It turned out that in both cases, the recommendations were little better than random guesses.
But what made the article interesting was his description of how the two groups reacted to the news that their judgments were worthless. They listened politely and understood what the statistical data meant. But they then returned to their tasks using the same selection approaches/criteria that were apparently worthless. I quote from the article on the reactions.
The Officer Training Advisors:
“We were downcast for a while after receiving the discouraging news. But this was the army. Useful or not, there was a routine to be followed, and there were orders to be obeyed.”
The Investment Advisers:
[After hearing their choices were no better than random] “We all went on calmly with our dinner, and I am quite sure that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before. The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the [investment] industry. Facts that challenge such basic assumptions — and thereby threaten people’s livelihood and self-esteem — are simply not absorbed. The mind does not digest them. This is particularly true of statistical studies of performance, which provide general facts that people will ignore if they conflict with their personal experience.”
What Is A Professional To Do?
It is fine if you are a doctor, plumber, or electrician. Cause and effect are quite clear. If you take certain actions, the appendix is successfully removed, the leak stops, or the light bulb comes on. But what if you have to make judgments about people or investments where things are not so clear? Companies pay head-hunters millions to find them “a few good men” and the investment industry is full of “professionals” offering investment advice. What are you to do if data clearly shows that your recommendations are no better than random guesses? Stop being a professional? Many professionals work extremely hard using methods that have taken them years to develop. What should they do? Start over? Let’s look a bit more closely at the roles of head-hunters and investment advisers.
Corporate Head Hunting
Head hunting is a bit of a jump from determining the best candidates for officer training school. But as I have reported earlier, corporate head hunting is a very interesting profession. Does anyone go back and check how well their selections did? Do Boards have any idea if their selections were any good? Or is it just a cover-up/legitimizing operation? I think the latter: Boards hire head hunters to justify their personnel choices and compensation awards. But let’s look a bit closer at how corporate head-hunters work. First, there are certain “qualifications” one must have to be considered for the senior executive “club” by large corporations and the “headhunter” firms that work for them. One’s college and professional networks are two of the more important qualifications. Another qualification: that you have been a senior corporate executive before. Nothing about past performance here.
By limiting searches in this manner, the pool from which selections are made is kept small. And this allows the few who qualify to earn much more than they would otherwise. Unfortunately for company stockholders, these characteristics do not accurately identify who can work effectively as senior corporate executives. Who is to say a young business school professor would not do just as well at running one of the Fortune 500 as one selected by the head-hunters? We don’t know.
Ever since Paul Samuelson wrote his path-breaking article in 1973 (“Proof that Properly Discounted Present Values of Assets Vibrate Randomly”), there has been a growing realization that it is not easy to pick stocks that regularly outperform the market. So what is an investment advisor to do? Well, he can tell his clients that buying two stocks is less risky than buying only one. And he can tell them that buying even more via either a mutual or exchange traded fund is even less risky.
He can tell them not to be day-traders. How about recommending “asset allocation”? Well you have to allocate your investments in some way. But note what happened to the more popular asset allocation categories in the 2008-2009 stock market collapse:
And what about the TV/financial blog “talking heads” who every morning attempt to explain every up and down tick of the stock market?
But the purpose here is not to praise or demean any investment approach. Rather, it is to ask how can investment advisors live with themselves knowing they have very little chance of outperforming anything.
Well, they can take at least some satisfaction in believing they make their clients feel better. And when their stock picks fall, their clients can blame them and not themselves. And just as with doctors, good investment advisor meetings can result in very positive placebo effects.
I return to where we started from. It is very difficult to be a professional advisor when you know your advice is just as likely to be bad as good. Humans in such situations have to develop coping mechanisms. I conclude with a couple more quotes from Kahneman:
“The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the [financial] industry. Facts that challenge such basic assumptions — and thereby threaten people’s livelihood and self-esteem — are simply not absorbed. The mind does not digest them. This is particularly true of statistical studies of performance, which provide general facts that people will ignore if they conflict with their personal experience.”
“…overconfident professionals sincerely believe they have expertise, act as experts and look like experts. You will have to struggle to remind yourself that they may be in the grip of an illusion.”