Thursday, 17 May 2012

Are intuition and instinct useful investment tools?

Which of the following portfolios would you buy into?

The one that made over 20% right? You probably want to know what the secret of its success is and whether it can be bestowed on you for a relatively small sum.

Well, sadly, there is no secret. Each portfolio was assigned 10 stocks picked (from a sample of 363 FTSE companies with names begging by A's) by a random number generator. Averages were taken and the results plotted as above. The idea is to show that even with just 26 portfolios there is a massive amount of variance in returns. 

The point to emphasis is that statistically speaking when there are thousands of investors there are bound to be quite a few who have been very succesful purely down to luck.  The difficultly comes in attempting to distinguish between what is caused by luck and what is caused by skill alone.  One reason for this is illusory superiority or that we all think we are better than we actually are. (E.g. over 50% of people think they are above average in terms of intelligence.)

Thus individuals are likely to attribute their success to their own positive attributes and or strategies rather than luck. Conversely, upon failure they are more likely to chalk this up to bad luck than any inherent inability to think.  Which means that even if you believe that this argument works for other people, you will still believe you are special case.

Therefore, I would like to consign to the universe of luck is that based on Gut instinct, feeling, or intuition as opposed to reasoned analysis of the pertinent factors.  Instincts of experts have continually been shown to be a poor judge in a variety of cases none more so than in investing. There are all sorts of ways we are unknowingly led astray from the rational course when we let our intuition take control leading us to sell losing stocks too slowly, sell winners too quickly, trade too much, choose stocks in the media eye and many many more.  There is no doubt that our instinct is a poor investor.

There will be many people out there, confident of their own instincts having had high returns which they will attribute to their impressive intuition. However, given two contrasting explanations for this, luck vs. Gut feeling it is rational to conclude that what is more likely to be the case (luck) is the case unless it can be proved otherwise.  (See Occam’s Razor for justification of this conclusion).

No comments:

Post a Comment