Your Broker Is Probably a Master of Illusion

Investment pros are often friendly and articulate, but that doesn’t mean they are dispensing sound financial advice.

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Daniel Kahneman is an Israeli-born psychologist. He won the Nobel Prize in economic sciences in 2002. He is best known for his work in behavioral economics, which attempts to explain how investors make decisions.

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In a thoughtful article adapted from his upcoming book, Thinking, Fast and Slow, Kahneman makes some interesting observations. He notes that his ability, and those of his colleagues, to identify potential leaders in the Israeli military was “better than blind guesses, but not by much.” This is surprising, since he had all the tools necessary to do an intelligent observation of military candidates as they performed their assignments in various training exercises.

Despite overwhelming evidence that he couldn’t make these predictions with any accuracy, the process continued without change. He would follow the same procedure, make predictions of little value, and act as if he was doing something useful.

As he reflected on this experience, he reached this insightful conclusion: “We are prone to think that the world is more regular and predictable than it really is, because our memory automatically and continuously maintains a story about what is going on, and because the rules of memory tend to make that story as coherent as possible and to suppress alternatives.”

Translation: Humans seek order, even when it is clear there is none. We are not prone to accept randomness, because it means we have no control.

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As applied to investing, Kahneman’s insights are compelling. He references studies of investors over an extended period which showed that, on average, stocks sold did better than stocks bought. It should be the other way around. More significantly, the more active the trader, the worse the results.

The poor performance of individual investors is replicated in actively managed mutual funds, where the fund manager attempts to beat a designated index like the S&P 500. Most actively managed funds underperform their index, even though they are managed by well trained investment professionals. Kahneman concludes that managers who outperform in any given year are “mostly lucky.”

Kahneman gives an interesting example of what he calls “the illusion of skill”. He analyzed the performance of 25 wealth advisers for eight consecutive years. He found no correlation in their performance from year to year. His conclusion: “The results resembled what you would expect from a dice-rolling contest, not a game of skill.”

I often ask investors why they are using advisers or brokers who claim to be able to beat the markets. Invariably they regale me with stories of their skill. The reality is there is no stock picking, market timing, or manager picking skill. The outperformance of some advisers, brokers, and fund managers in any given year can be easily explained by luck. Skill persists. Luck doesn’t.

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Remember these lessons the next time you watch an investment pro on television telling you to buy a certain stock or predicting the direction of the market. He may be right or wrong, but he is not exhibiting any skill. You could do just as well or better by flipping a coin.

The only skill is acting like he has a skill. Investment pros are often friendly, articulate, and extremely confident. Kahneman believes it is all an illusion. Unfortunately, for you it can be a very expensive one.

Dan Solin is the author of the New York Times best sellers, The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, and The Smartest Retirement Book You'll Ever Read. His new book, The Smartest Portfolio You'll Ever Own, was released in September, 2011.

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