Sunday, January 6, 2013

You're Not That Smart

I'm used to feeling confused.  This is probably because of all the philosophy I've read.  Socrates said that the only thing he knew for sure was that he didn't know anything.  And nothing will make you more confused faster than dipping into a book by a German philosopher like Hegel or Heidegger.  Philosophy is all about getting comfortable with being confused.  This confusion is different from that which you might experience in a science class--if you're confused there, you simply need to turn to the next page or work through the homework.  Philosophy is fundamentally confusing, because no one has the answers to the Big Questions.

You might wonder what possible value being confused could have.  Philosophy majors have trouble justifying "what are they going to do with that."  The funny thing is that philosophy majors do better on standardized tests than any other majors.  They don't make as much money at the beginning of their career, but they tend to make more than other non-engineering majors later in life.  And philosophers pick up difficult fields like computer programming very quickly.  Perhaps there is something to being confused.

One of the main lessons I take from Nate Silver's new book is that there are many areas in which people think they are smarter than they really are.  Take poker, for example.  For a brief period of time in the early 2000's, Silver was a professional poker player.  Because of the poker boom, there were a lot of suckers that better players like him could thrive on.  The problem is that the skill set required to play poker follows a Pareto principle, or an 80-20 rule.  That is, with 20% effort, you can make the same decisions as the best players 80% of the time.  (Silver says: learn the probabilities, fold when your cards aren't good, and make some attempt to project what other players have).  It takes an incredible amount of effort to become very good.  So when the poker boom turned to bust, it suddenly became very difficult for average players to make any money.

Because of the amount of chance involved and our bias towards ourselves, it is nigh impossible to be objective about our own poker skills.  Most people who stick with poker start out doing very well--otherwise they would just give it up.  When they start to do badly, it could be the result of chance or their lack of skill.  Few have the patience to stick around and find out.

People also delude themselves on a habitual basis when it comes to investing.  Everyone thinks they have a rule to predict the market, or that their broker does.  Henry Blodget, CEO of Business Insider says: “‘Everybody thinks they have this supersmart mutual fund manager. He went to Harvard and has been doing it for twenty-five years. How can he not be smart enough to beat the market? The answer is: Because there are nine million of him and they all have a fifty-million-dollar budget and computers that are collocated in the New York Stock Exchange. How can you possible beat that?’”  No one seems to believe it, but there is no statistically significant relationship between a fund's performance one year and the next.  (Daniel Kahneman has a great explanation of this blindness).

Silver shows that a foolproof forecasting strategy is not enough, since transaction costs may eat up your earnings.  Furthermore, even if your strategy is sound, most people are psychologically unable to diverge from the herd to buy when everyone else is selling.  His advice is to follow the 80-20 rule and stick with indexed funds.  80% of the time, they're going to do as well as the very best traders could.  If you've come up with a set of heuristics to 'beat the market', you're probably kidding yourself. 

I recently took a Finance course through Venture-Lab.  Though the class was difficult and I was often confused, it was taught as if markets could be predicted with mathematical precision.  (The professor teaches in Stanford's school of Management Science and Engineering, after all!).  The implication was that if you're not making correct predictions about future returns, you just need a more complex equation.  If you can do the math, you're guaranteed to have an exciting and profitable career.  I don't buy it.

I'm more amenable to Silver's philosophy.  If you have good analytic skills, he says, look for the fields where the smart people are not flocking.  Wall Street is already flooded by ivy leaguers.  What are your chances of making it big?  Silver admits that he was lucky to get into baseball statistics, poker, and political prediction before the fields were dried up.  Look where it got him.  Rather than falling for any get-rich-quick schemes predicated on certainty, I'll stick with Socrates.


  1. Great post. It was funny to me the wave of people who claimed to be pursuing or interested in pursuing the career poker player path. I was always a little skeptical of hearing everyone claim to have above-average skills... As with investing, poker tends to bring out the stories of victory, and fewer stories of defeat.

    1. Thanks for the comment, Complete Method. Did you know that all drivers are above average too? ;)

  2. Correction: all MALE drivers are above average.

  3. I think men and women are equally bad at evaluating themselves!


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