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The Entire Investment Profession Is Built On An Illusion Of Skill

Robert Lenzner, Forbes Staff
INVESTING | 12/31/2011
Article from FORBES

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.

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 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.

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.”

Article from FORBES

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