Nassim Taleb on mistaking luck as skill in financial markets:
There is one world in which I believe the habit of mistaking luck for skill is most prevalent – and most conspicuous – and that is the world of markets. By luck or misfortune, that is the world in which I have operated most of my adult life. It is what I know best. In addition, economic life presents the best (and most entertaining) laboratory for the understanding of these differences. For it is the area of human undertaking where the confusion is greatest and its effects the most pernicious. For instance, we often have the mistaken impression that a strategy is an excellent strategy, or an entrepreneur a person endowed with “vision,” or a trader a talented trader, only to realize that 99.9% of their past performance is attributable to chance, and chance alone. Ask a profitable investor to explain the reasons for his success; he will offer some deep and convincing interpretation of the results. Frequently, these delusions are intentional and deserve to bear the name “charlatanism.”
Contrast participants in financial markets to another group of people with similar characteristics: professional poker players. Poker games, like financial markets, are zero-sum in that one participant cannot do better without making another player worse off. Poker players and investors must make decisions under situations of incomplete and imperfect information. And most importantly, there is a tremendous amount of short-term luck involved in poker — often times one can make the right decision but end up losing money.
Consider the best starting hand in Texas Hold’Em versus one of the statistically worst starting hands: pocket aces versus seven two off-suit. Even in this most favorable situation possible, the pocket aces has only a 87 percent chance of winning the hand. And these are one of the easiest hands to play correctly! Most situations involve considerable uncertainty: top pair versus a flush draw, for example. The role of luck in poker is so large that paradoxically, both players can be making the right move (in that they have positive expected value) by staying in the hand. Thus, the consensus among poker players is that anyone reaching the final table in a tournament has had a great deal of short-term luck. Often times, due to the increasing blind structure, the remaining players in a tournament must survive multiple all-in, coin flip situations.
Acknowledging that poker has a great deal of short-term luck, why is it that poker is generally recognized as a game of skill? From my own personal study of the game, I can confidently conclude that, at least for low-limit games, poker can be beat through dedicated study.
So why can’t the same be said about financial markets? Economists generally agree that investors cannot achieve consistent market-beating returns and recommend an indexing approach instead.
Daniel Kahneman, recipient of the Nobel Prize in Economics, presents a plausible explanation in a @Google Talk. Watch (at the very least) 14:00 to 18:00.
Kahneman suggests that only in the regular world — a world defined by rules and similar, repeated experiences — can intuitive expertise be developed. He presents an interesting example: an anesthesiologist versus a radiologist. An anesthesiologist often sits by a patient’s head throughout a surgery, constantly monitoring a wide variety of patient vital signs. The anesthesiologist gets excellent and clear feedback when something goes wrong or right. The radiologist, on the other hand, lives in what Kahneman describes as the chaotic world. When diagnosing whether a patient has a tumor, for example, the radiologist does not know whether he was right in his diagnosis until much later. In other words, the radiologist isn’t faced with enough repeated experiences to develop intuitive expertise.
Kahneman goes on to say that he believes participants in financial markets live in the chaotic world and thus skill in stock picking cannot be developed. Could it be that financial markets are so dynamic that there aren’t enough repeated experiences for market participants to truly gain expertise?