Monday, July 16, 2012

illusion of understanding

The illusion of understanding occurs frequently due to selection bias and confirmation bias. By selecting only data that support one's position and ignoring relevant data that would falsify or compromise one's position, one can produce a convincing but misleading argument. By seeking only examples that confirm one's belief and by ignoring examples that disconfirm it or reveal the insignificance of the data you've put forth, one can easily create the illusion of understanding. The illusion of understanding is particularly prominent in the field of economic forecasting.

Economic forecasters employ a variety of methods and formulas. Some forecasters, some of the time, make  successful predictions, apparently on the basis of their methods. They appear to have identified real patterns in the market. The reality, however, is that all forms of successful economic forecasting are illusory because the economy is a complex system significantly affected by irrational forces (Thomas Kida: Don't Believe Everything You Think: The 6 Basic Mistakes We Make in Thinking). In short, there is no logical system that can predict the market because the market isn't logical. Anyone who thinks he has discovered a system that can "beat" the market is deceiving himself. (Note: "beating the market" means doing better than an index of funds, such as Standard and Poor's 500, over some period of time.)

One fact hinders acceptance of the claim that markets are unpredictable: some people have correctly predicted that the market would rise or fall and some have made a killing from time to time by following their unique and special method of prediction. Yes, and a broken clock is right twice a day and some people do win the lottery using the dates of their grandchildrens' birthdays as a guide to selecting their numbers. Even though some people have made correct predictions about the market, those predictions should not be taken as evidence of the power of any particular method of economic forecasting. Psychics make correct predictions from time to time. Does that mean they're really psychic? Like psychics, however, economic forecasters who are right from time to time take full credit for their correct predictions. They made them on the basis of skill; luck had nothing to do with it. Right.

Think about it. If stock analysts could really beat the market consistently, wouldn't they be stinking rich? Do you really think they are a clan of benevolent elves whose only goal is to help people like you get rich from their technical advice? Their cousins appear in infomercials all the time, telling stories about unfathomable riches that await you if you invest in their program. That's how they make their money: not by using their program, but by selling it to others!

What about the superstars? Aren't there freelancers and top mutual fund managers who consistently beat the market because of their special expertise? Aren't there investment managers from pension funds, insurance companies, and foundations that consistently beat the market because of their genius? No. It's easy to pick a person or a fund and show its superiority to the market, as long as you are very selective about what time period you evaluate. Over the long haul, however, no one person and no fund does better than chance at beating the market (William A. Sherden: The Fortune Sellers: The Big Business of Buying and Selling Predictions). It is true that some fund managers do better than others over certain periods of time. The few examples of consistently superior performance over a period of, say, four or five years, however, are what one would expect by chance (Burton Malkiel: A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. Revised and updated). "Analyses of the Forbes honor role funds over the period 1973 to 1998 indicate that they underperformed the S&P 500 stock index (Kida 2003: p. 142; Malkiel 2007). In short, there's no scientific evidence that professionally managed funds, as a group, perform any better than a randomly selected group of stocks (Kida 2003: p. 143; Malkiel 2007).

What about the geniuses at the Fed, the Council of Economic Advisers, the Congressional Budget Office, the Bureau of Economic Analysis, and the National Bureau of Economic Research? Surely these top economic advisers with their large budgets and sophisticated tools of analysis are able to consistently make accurate predictions about such things as the gross national product and inflation. Wrong! "A review of twelve studies on forecasting accuracy, covering the periods 1970 to 1995, concluded that economists can't even predict the major turning points in our economy. The top economic institutions listed above were wrong in their predictions of forty-six out of forty-eight turning points in our economy (Kida 148). That's about a 4 percent success rate. Not too impressive. Nevertheless, nobody every went broke claiming to understand the secret of the market. Books that make such claims might be a dime a dozen, but millions of people are standing in line to buy them (figuratively speaking, of course).

Another area where the illusion of understanding flourishes is in the Success Guru business. I'll have more to say about these folks in my upcoming podcast episode on Skepticality podcast (#187). It should be out around July 31.

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