Wednesday, June 28, 2017

Thinking, Fast and Slow III

The book is moving too slowly for my taste, but it is still worth reading for the research it describes. I am getting the feeling that Kahneman is the beneficiary of his collaboration with Amos Tversky, who was probably the brains behind Kahneman's Nobel. Tversky died in 1996, and Kahneman received the award in 2002. He mentions Tversky so often that you can't help but think that he somehow feels guilty, though their relationship may also have been close. Kahneman is hardly an idiot, yet so far in the book, which is padded with personal anecdotes, he doesn't seem to have a good grasp of the implications of his work. I suppose that I should have expected this, since "bestseller" is usually the kiss of death for any book if you're seeking substance, intellectual rigor and good exposition.

Part III, Overconfidence, meshes with many of the points I've made on this blog. Kahneman considers overconfidence a feature of System 1. Generally, pundits and experts have no idea what they're talking about, and everyone is bad at predicting the future. It has been demonstrated that well-designed algorithms outperform professional opinion in several fields. Kahneman makes some clear statements that are worth quoting:

Most of us view the world as more benign than it really is, our own attributes as more favorable than they truly are, and the goals we adopt as more achievable than they are likely to be. We also tend to exaggerate our ability to forecast the future, which fosters optimistic overconfidence. In terms of its consequences for decisions, the optimistic bias may well be the most significant of the cognitive biases. Because optimistic bias can be both a blessing and a risk, you should be both happy and wary if you are temperamentally optimistic....

Experts who acknowledge the full extent of their ignorance may expect to be replaced by more confident competitors, who are better able to gain the trust of clients. An unbiased appreciation of uncertainty is a cornerstone of rationality – but it is not what people and organizations want. Extreme uncertainty is paralyzing under dangerous circumstances, and the admission that one is merely guessing is especially unacceptable when the stakes are high. Acting on pretended knowledge is often the preferred solution.

Kahneman portrays optimism as the driving force of capitalism, with an endless stream of delusional thinkers trying and usually failing in new businesses, but with successes occurring frequently enough to feed a growing economy. Oddly, his analysis seems to end there, without a hint of the need for further discussion. He says that even the most successful corporate executives have no idea what the future will bring, and I wonder what he would have to say about the risks associated with the election of incompetent politicians. Donald Trump perfectly fits the book's model for optimistic, delusional thinkers who overestimate their skills, yet he has been democratically elected to the most powerful position in the world. Are election results to be accepted regardless of the ignorance that they display?

One area in which I disagree with Kahneman somewhat is in his analysis of investment decisions. He takes the orthodox economics position, in which stock selection is seen as a fool's game, and he recommends buying indexes as a sounder choice. There have been simplistic arguments raging for decades on this topic, and I still think that a case can be made for active investment versus passive investment in indexes. All stock market indexes contain companies whose financial prospects are worse than those of other companies. It does not necessarily require luck to identify some of them and exclude them from an investment portfolio. For example, The United States Leather Company, which was a component of the Dow Jones Industrial Average when it originated in 1896, could have been identified as a poor investment whose exclusion would have provided a better return than the index before it was removed in 1905. It is true that most stock investments do not on average outperform indexes, but there are a few actively managed mutual funds that consistently outperform their indexes for decades at a time, and this does not appear to be the result of luck. Identifying which actively managed funds to buy is difficult but not completely impossible. There are advantages to the lower fees charged by index funds, but that is only one of many factors to consider. On the whole, I think that the most significant obstacles to sound stock investing are the sheer number of products available and the shortage of good advice, which both serve the interests of the financial services industry. Index funds come in many forms and have added to the confusion, and it isn't easy to know which ones to buy. Kahneman also embraces the efficient market hypothesis, which I consider to be one of the major oversimplifications in the field of economics. Ironically, Kahneman seems to be associating himself with a group of experts who don't know what they're talking about, in this instance making his own advice paradoxical.

I am currently reading Part IV, which covers the more mathematical aspects of Kahneman's work, and it is followed by his conclusions in Part V.

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