“Thinking, fast and slow” by the Nobel prize-winning psychologist Daniel Kahneman continues to ride high in the business book bestseller lists. I dare say therefore that copies have found their way into the hands of managers of investment firms. But how many of them, I wonder, have reflected on the implications for the businesses in which they are involved – and how many, alternatively, have quietly binned the book as too disturbing to risk leaving lying around the office?
As students of the evolving discipline of behavioural finance will know, Prof Kahneman has for many years been at the forefront of research into the many cognitive and unseen biases which in practice compromise our ability as human beings to make optimal and effective decisions. This research has been instrumental in deepening our understanding of the way that the financial world works, without so far providing a comprehensive alternative framework to the flawed rationalist school that underpins modern financial theory and practice.
These insights have been of great value to the investment profession, but they also come at a painful cost, in the sense that they also undermine many of the central assumptions on which the business models of financial services business are based. Fund managers and financial advisers, it turns out, are rich sources of material for the dysfunctionality which Prof Kahneman and his fellow researchers have made their life’s work.
Central to this is the issue of investment skill. While it is easy to see how professional investors can (and do) profit from the errors of amateurs, Kahneman puzzled over how professionals could profit at each other’s expense, for example through superior stockpicking. In aggregate of course, as we know now all too well, they cannot. If there was clear-cut evidence of skill, it would show up in the persistence of individual fund manager performance rankings and correlations between those rankings from year to year.
Yet that evidence is simply not available for the great majority of active fund managers. Prof Kahneman records how he was able to analyse a spreadsheet from a wealth management firm, containing the performance of 25 of its wealth advisors’ portfolios over a period of years. When he calculated the cross-correlations between the outcomes for each pair of years in the eight-year sample, the correlation turned out to be exactly .01 – in other words, effectively zero.
This firm, he and Richard Thaler concluded, was rewarding luck as if it were skill. Yet, says Prof Kahneman, while the finding of low correlation was not a total surprise to the management, the fact that the correlation was actually zero did indeed take them aback. “I have no doubt” he goes on “that both our findings and their implications were quickly swept under the rug and that life in the firm went on just as before”.
Why so? Prof Kahneman’s explanation is primarily behavioural. Facts that challenge basic assumptions – and therefore threaten people’s livelihoods and self-esteem – are, he says, “simply not absorbed” by the human mind. It is simply too difficult to accept the implications of such an unpalatable finding. I am not sure that I would be quite so charitable, as it is clear that quite a few financial service firms remain in business despite knowing full well that their products and service have little or no value.
Yet there are other all too plausible reasons, many of them common to other professions, why fund managers and advisers can sincerely continue to believe that in their own cases their performance is a matter of skill rather than luck. One is that most are highly educated individuals who undoubtedly employ “high level skills” in going about their business.
That helps to create a powerful feeling of confidence, which in turn reinforces the “illusion of skill”. Another factor is that professional investors operate in a powerful professional culture supported by increasingly onerous qualifications and entrance hurdles. (“We know” says Prof Kahneman bluntly “that people can maintain an unshakeable faith in any proposition, however absurd, when they are sustained by a community of like-minded believers”).
His conclusion is that the entire fund management industry is built largely on “an illusion of skill”. This illusion, in his view, is “deeply ingrained in the culture of the industry”. This unflattering verdict overlooks, I think, the fact that the skill which many professional investors bring to their task is precisely the reason why markets are, in general, sufficiently competitive to prevent the effects of that skill showing up in performance statistics. It is too sweeping a generalisation. Nevertheless his critique presents a powerful challenge to every industry participant to prove his or her worth.
My principal reaction to this fascinating book, however, I must confess, was that there are others who might also profitably reflect on his findings. High on that list is Ben Bernanke, the head of the Federal Reserve. One of the most striking findings of behavioural finance is the fallibility and overconfidence of experts, whose judgments about future events, based on overconfidence in their own ability and sometimes also a “halo effect”, are frequently trumped by ridiculously simple algorithms that do the job of predicting future events much better. The more you know, moreover, the less reliable you risk becoming.
In practice, says Prof Kahneman, you should only think of relying on the confidence of powerful and knowledgeable experts if their field of operation is one in which uncertainty plays little or no part. This is self-evidently not true of the global economy. Yet Mr Bernanke not only declares, with his famous “helicopter” analogy, that deflation can always be avoided but that he is also “100%” confident that he can prevent a recurrence of inflation as well. Neither statement should, Prof Kahneman’s research tells us, inspire confidence. Think the Wizard of Oz instead.