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Do you believe that you can consistently beat the stock market if you put in the effort? --that some people have extrasensory perception? --that crime and drug abuse in America are on the rise? Many people hold one or more of these beliefs although research shows that they are not true. And it's no wonder since advertising and some among the media promote these and many more questionable notions. Although our creative problem-solving capacity is what has made humans the successful species we are, our brains are prone to certain kinds of errors that only careful critical thinking can correct. This enlightening book discusses how to recognize faulty thinking and develop the necessary skills to become a more effective problem solver. Author Thomas Kida identifies "the six-pack of problems" that leads many of us unconsciously to accept false ideas: · We prefer stories to statistics. · We seek to confirm, not to question, our ideas. · We rarely appreciate the role of chance and coincidence in shaping events. · We sometimes misperceive the world around us. · We tend to oversimplify our thinking. · Our memories are often inaccurate. Kida vividly illustrates these tendencies with numerous examples that demonstrate how easily we can be fooled into believing something that isn't true. In a complex society where success--in all facets of life--often requires the ability to evaluate the validity of many conflicting claims, the critical-thinking skills examined in this informative and engaging book will prove invaluable.… (more)
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All this may well be right, but Kida’s error lies in what he does with these data:
"Oftentimes investors move their money into a fund that has experienced good recent performance. However, statistcs tell us that we have regression to the mean. That is, if a fund is currently outperforming the market, its performance is likely to drop in the future to bring it back to average. And so, if we buy into a fund right after it has posted recent gains, we’re likely to be in for a fall. In effect, going after strong past performance often means we take money out of funds that are likely to rebound, and put it into funds that are ready to drop. "
Kida has misunderstood regression towards the mean, and has committed an error known as the gambler’s fallacy (which he had already discussed in an earlier chapter).
Let us suppose that fund manager’s are indeed irrelevent, and that a fund has a 50/50 chance of underperforming or overperforming the market each year. If this assumption is indeed correct - and this is indeed Kida’s argument, then whether the fund will outperform or underperform the market this year is entirely unconnected with whether the fund outperformed or underperfomed the market last year.
If Kida is correct, then it makes no difference in the long run whether we leave the money where it is or move it (except for dealing charges incurred of course), because all funds will eventually do equally well.
If we buy into a fund right after it has posted gains then it is wrong to expect that we are in for a big fall. We are just as likely to do well (or badly) as if we buy into a fund that recently posted very poor gains.
But what is regression towards the mean then?
If we take the whole “population” of funds, and we measure all their respective gains each year, we come up with a mean (average) gain for all funds. Now, suppose we choose the 100 best performing funds and measure their gains - because these are the best perfroming funds, their mean gain will, of course, be higher than the mean for all funds.
Let us suppose that their mean gain was twice that of all funds.
Now next year we measure these means again. The mean gain for all funds and the mean for what were last year’s 100 best funds. What we find is that the mean for the 100 best funds of last year is now much closer to the mean of all funds. If fund performance is entirely random then that mean may be less than the mean for all funds, or more - but it will almost certainly be less than twice that of all funds.
Why does this happen? Because there was nothing special about the 100 best funds, and there is no guarantee that the funds that did well last year will do well this year. Thus their average should approach the population average.
But any individual fund could still be in the top 100 - and we would expect that to be the case. Regression towards the mean is only concerned with averages.
Still not convinced?
By Kida’s principle - moving money into an outperforming fund sets you up for a fall. Thus it would follow that moving money into an underperforming fund will set you up for a gain. Therefore, one should put money into the underperforming funds as the best strategy for success.
But it doesn’t work. Because Kida is wrong.
If the performance of a fund is random, the best strategy for success is to buy the fund with the lowest charges and leave your money where it is (or better still - just buy the shares that all the funds hold, and hold the shares).
1. We perfer stories to statistics
2. We seek to confirm, not to question, our ideas
3. We rarely appreciate the role of chance and coincidence in shaping events
4. We sometimes mispervieve the world around us
5. We tend to
6. We have faulty memories.
I only tolerated the condecention through #2. It wasn't faulty logic, but proof-by-repeated-assertion becomed pedantic.
The summary (for as far as I got) was that critical thinking (the scientific method) is a good tool, but isn't often used. A mistake he makes, IMHO, is that it is the only tool. There's are a number of versions of the "Faith without Science is XXX; Science without Faith is YYY" that encapsulate some knowledge this author does not acknowledge.