The Illusion of Skill

Posted on November 2, 2011
Filed Under commerce, metaphysics | 3 Comments

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The Occupy Wall Street protests have prompted a great deal of discussion regarding income discrepancy, much of it accompanied from the side of the greedy sociopaths by the “we’ve earned it, we work harder and we’re smarter than everyone else.” line of logic. Interestingly, many of the top earners work in investment banking, selecting shares to buy and sell.  They believe that by studying the market and keeping themselves abreast of local and international news they can make decisions about which way the market will go and how best to invest the funds of their clients. There’s only one problem. Their results are very rarely any better than chance as this fascinating article about how “cognitive illusion” blinds us to reason demonstrates.  It’s a long but worthy read with a number of tasty insights into the human condition generally, as well as that of the corporate investor.

From The Guardian

Few stock pickers, if any, have the skill needed to beat the market consistently, year after year. Professional investors, including fund managers, fail a basic test of skill: persistent achievement. The diagnostic for the existence of any skill is the consistency of individual differences in achievement. The logic is simple: if individual differences in any one year are due entirely to luck, the ranking of investors and funds will vary erratically and the year-to-year correlation will be zero. Where there is skill, however, the rankings will be more stable. The persistence of individual differences is the measure by which we confirm the existence of skill among car salespeople, orthodontists or golfers.

Mutual funds are run by highly experienced and hardworking professionals who buy and sell stocks to achieve the best possible results for their clients. Nevertheless, the evidence from more than 50 years of research is conclusive: for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. Typically at least two out of every three mutual funds underperform the overall market in any given year.

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