Illusion of Skill in Stock Trading
Kahneman argues that the demanding analytical work of stock picking can create confidence without demonstrating an ability to outperform the market. Professional culture can reinforce that confidence even when a track record offers little support.
THE IDEA
What Supports the Illusions of Skill and Validity?
Cognitive illusions can be more stubborn than visual illusions. What you learned about the Müller-Lyer illusion did not change the way you see the lines, but it changed your behavior. You now know that you cannot trust your impression of the length of lines that have fins appended to them, and you also know that in the standard Müller-Lyer display you cannot trust what you see. When asked about the length of the lines, you will report your informed belief, not the illusion that you continue to see.
In contrast, when my colleagues and I in the army learned that our leadership assessment tests had low validity, we accepted that fact intellectually, but it had no impact on either our feelings or our subsequent actions. The response we encountered in the financial firm was even more extreme. I am convinced that the message that Thaler and I delivered to both the executives and the portfolio managers was instantly put away in a dark corner of memory where it would cause no damage.
Why do investors, both amateur and professional, stubbornly believe that they can do better than the market, contrary to an economic theory that most of them accept, and contrary to what they could learn from a dispassionate evaluation of their personal experience? Many of the themes of previous chapters come up again in the explanation of the prevalence and persistence of an illusion of skill in the financial world.
The most potent psychological cause of the illusion is certainly that the people who pick stocks are exercising high-level skills. They consult economic data and forecasts, they examine income statements and balance sheets, they evaluate the quality of top management, and they assess the competition. All this is serious work that requires extensive training, and the people who do it have the immediate (and valid) experience of using these skills. Unfortunately, skill in evaluating the business prospects of a firm is not sufficient for successful stock trading, where the key question is whether the information about the firm is already incorporated in the price of its stock. Traders apparently lack the skill to answer this crucial question, but they appear to be ignorant of their ignorance. As I had discovered from watching cadets on the obstacle field, subjective confidence of traders is a feeling, not a judgment. Our understanding of cognitive ease and associative coherence locates subjective confidence firmly in System 1.
Finally, the illusions of validity and skill are supported by a powerful professional culture. We know that people can maintain an unshakable faith in any proposition, however absurd, when they are sustained by a community of like-minded believers. Given the professional culture of the financial community, it is not surprising that large numbers of individuals in that world believe themselves to be among the chosen few who can do what they believe others cannot.
When to use it
An amateur investor evaluating their stock-picking track record and considering the role of luck versus skill.
A financial advisor assessing whether their active management strategy is justified or if passive investing would be more appropriate.
A manager reviewing the validity of internal assessment tests and deciding whether to rely on them despite low predictive power.
A portfolio manager reflecting on the influence of professional culture on their investment decisions and willingness to accept evidence.
FROM THEORY TO EVERYDAY LIFE
In practice
Army Leadership Assessment Tests
The author and colleagues learned that their leadership assessment tests had low validity. Despite accepting this intellectually, it had no impact on their feelings or subsequent actions, illustrating the stubbornness of cognitive illusions.
Financial Firm Presentation
Kahneman recalls presenting evidence about the limits of stock-picking skill with Thaler to executives and portfolio managers. He believed the audience quickly put the message aside rather than revise its confidence.
A MOMENT TO REFLECT
Put it to work.
Why do investors continue to believe they can beat the market despite overwhelming evidence that most cannot?
How does the professional culture of finance reinforce overconfidence and the illusion of skill?
In what ways does subjective confidence act as a feeling rather than a judgment, and how does that affect decision-making?
CONTINUE THE CONVERSATION
Source texts
- Thinking, Fast and Slow (Daniel Kahneman)