Monday, November 7, 2011

"Why do Wall Street traders have such faith in their powers of prediction, when their success is largely down to chance?"

From The Guardian:

Daniel Kahneman: How cognitive illusions blind us to reason
    Otto Dettmer
    Illustration by Otto Dettmer. Photograph: Otto Dettmer for the Observer
    ...In 1984, my collaborator Amos Tversky and I, and our friend Richard Thaler, now a guru of behavioural economics and co-originator of "nudge" theory, visited a Wall Street firm. Our host, a senior investment manager, had invited us to discuss the role of judgment biases in investing. I knew so little about finance that I did not even know what to ask him, but I remember one exchange. "When you sell a stock," I asked, "who buys it?" He answered with a wave in the vague direction of the window, indicating that he expected the buyer to be someone else very much like him. That was odd: what made one person buy and the other sell? Most of the buyers and sellers know that they have the same information; they exchange the stocks primarily because they have different opinions. The buyers think the price is too low and likely to rise, while the sellers think the price is high and likely to drop. The puzzle is why buyers and sellers alike think the current price is wrong. What makes them believe they know more about what the price should be than the market does? For most of them, that belief is an illusion.

    Most people in the investment business have read Burton Malkiel's wonderful book A Random Walk Down Wall Street. Malkiel's central idea is that a stock's price incorporates all the available knowledge about the value of the company and the best predictions about the future of the stock. If some people believe that the price of a stock will be higher tomorrow, they will buy more of it today.
    This, in turn, will cause its price to rise. If all assets in a market are correctly priced, no one can expect either to gain or to lose by trading. Perfect prices leave no scope for cleverness, but they also protect fools from their own folly. We now know, however, that the theory is not quite right. Many individual investors lose consistently by trading. The first demonstration of this startling conclusion was collected by Terry Odean, a finance professor at University of California Berkeley who was once my student....MUCH MORE