Choose The Game You Play Wisely
Expert decision making, especially in the stock-picking world, is not reliable. Stock picking by speculators is not a skill that can be mastered. Value investing needs to be thought of in the context of playing the long-term odds. Daniel Kahneman’s remarkable work, ‘ Thinking Fast and Slow ‘, discusses in detail overconfidence in the professional world and when experts can be trusted in their predictions. He had collaborated with psychologist Gary Klein on a project that researched this very question, as Klein was prone to believe that expert intuition was to be trusted when a decision had to be made, while Kahneman had concluded that algorithms are more trustworthy than human intuition. Their work was interesting, to say the least. Kahneman felt that algorithms could drown out the noise that human emotion brought to the decision-making process, but Klein laughed at the very thought of a machine making a critical decision in the heat of the battle. After numerous discussions and long debates, the question was asked what type of “expert” they were analyzing? Klein had in mind nurses and fire fighters and the like; people who had to make split-second decisions because lives depended on it. However, Kahneman had been thinking of political science forecasters and stock pickers. Kahneman had earlier done studies at a financial firm, analyzing the company’s stock advisors. His findings were not encouraging. Kahneman had been given data on the firm’s advisors and their records over the course of an 8-year period. When the rankings of the advisors were compared year by year, Kahneman found a correlation .01 – basically showing that the stock-picking skill was non-existent within the firm. Those who did well one year were likely to do worse the following year and vice versa; regression to the mean prevailed. He notes that the executives at the firm as well as the advisors basically swept the findings under the rug. They were collecting fees from their clients anyway, right? Kahneman and Klein concluded that stock picking occurs in a low-validity environment. There are no set rules to play within, like a grandmaster would encounter in a game of chess. Intuition can be trusted in such a high-validity world, proven by Gary Kasparov’s success against IBM’s (NYSE: IBM ) Deep Blue in a number of man vs. machine chess matches. The stock-picking world is different, with too many variables and moving parts to ever become “skilled” or “expert”. Stock picking is more like the roll of the dice than a game of poker, according to Kahneman. This is why mutual funds, with their fees and transaction costs, constantly underperform the overall markets. Just ask Jack Bogle! However, anyone who has been around the investing world for more than about 10 minutes is familiar with Warren Buffett’s ‘ The Superinvestors of Graham-and-Doddsville ‘. Mr. Buffett eloquently refutes the idea that the stock market is efficient and discredits the belief that success in investing comes down to a coin flip. It is hard to argue with Mr. Buffett’s logic, backed by his exceptional and illustrious decades-long performance. Buffett fits Kahneman’s description of the former in the “hedgehog and the fox” parable. The hedgehog is good at one thing. He believes himself to be an expert and, so, is overconfident in his predictions. The fox is a more global thinker and opened-minded. He is mindful of the black swan and concedes that he will be wrong on occasion. He constantly questions his position and looks for flaws in his logic. While the hedgehog’s ego prevents him from admitting his mishaps, the fox looks at mistakes as learning opportunities. The fox has historically outperformed the hedgehog. So, what can we conclude from all of this? Many have gone into great detail on the differences between speculating and investing. I categorize Kahneman’s group of stock advisors as speculators, as I do many money managers of today. They have little incentive to outperform the indexes, but their careers are on the line if they make a wrong call. Due to the structure and competitiveness of corporate America and the “instant gratification” mindset that characterizes today’s “investors”, money managers don’t have 5 years to wait for an investment to pan out. Status quo keeps them employed. The proven way is the long-term, value investment strategy employed by Buffett and his skulk of foxes. A true poker player knows that he’ll succeed eventually, if he continues to play the odds. Know that you will occasionally be wrong, keep an open mind, learn from your mistakes, and don’t listen to the pundits of mass media. Speculating is a game of roulette; invest like you’re playing Texas Hold ’em for the long term.