Thinking, Fast and Slow

by Daniel Kahneman

Both descriptions sound right ...

Because of the halo effect, we get the causal relationship backward: we are prone to believe that the firm fails because its CEO is rigid, when the truth is that the CEO appears to be rigid because the firm is failing. This is how illusions of understanding are born.

Knowing the importance of luck, you should be particularly suspicious when highly consistent patterns emerge from the comparison of successful and less successful firms.

Because luck plays a large role, the quality of leadership and management practices cannot be inferred reliably from observations of success.

A study of Fortune’s “Most Admired Companies”

finds that over a twenty-year period, the firms with the worst ratings went on to earn much higher stock returns than the most admired firms.

The average gap must shrink, because the original gap was due in good part to luck, which contributed both to the success of the top firms and to the lagging performance of the rest. We have already encountered this statistical fact of life: regression to the mean.

Stories of how businesses rise and fall strike a chord with readers by offering what the human mind needs: a simple message of triumph and failure that identifies clear causes

and ignores the determinative power of luck and the inevitability of regression. These stories induce and maintain an illusion of understanding, imparting lessons of little enduring valu...

Because of confidence by coherence, the subjective confidence we have in our opinions reflects the coherence of the story that System 1 and System 2 have constructed.

The amount of evidence and its quality do not count for much, because poor evidence can make a very good story.

We took them to the obstacle field, we faced them with the wall, they lifted the log, and within a few minutes we saw their true natures revealed, as clearly as before. The dismal truth about the quality of our predictions had no effect whatsoever on how we evaluated candidates and very little effect on the confidence we felt in our judgments and predictions about individuals.

Confidence is a feeling, which reflects the coherence of the information and the cognitive ease of processing it.

declarations of high confidence mainly tell you that an individual has constructed a coherent story in his mind, not necessarily that the story is true.

Most of the buyers and sellers know that they have the same information; they exchange the stocks primarily because they have different opinions. The buyers think the price is too low and likely to rise, while the sellers think the price is high and likely to drop.

To determine whether those ideas were well founded, Odean compared the returns of the stock the investor had sold and the stock he had bought in its place, over the course of one year after the transaction.

Individual investors predictably flock to companies that draw their attention because they are in the news. Professional investors are more selective in responding to news. These findings provide some justification for the label of “smart money” that finance professionals apply to themselves.

for a large majority of fund managers, the selection of stocks is more like rolling dice than like playing poker. Typically at least two out of every three mutual funds underperform the overall market in any given year.

The subjective experience of traders is that they are making sensible educated guesses in a situation of great uncertainty. In highly efficient markets, however, educated guesses are no more accurate than blind guesses.

To answer the question, I computed correlation coefficients between the rankings in each pair of years: year 1 with year 2, year 1 with year 3, and so on up through year 7 with year 8. That yielded 28 correlation coefficients, one for each pair of years. I knew the theory and was prepared to find weak evidence of persistence of skill. Still, I was surprised to find that the average of the 28 correlations was .01. In other words, zero.

Our message to the executives was that, at least when it came to building portfolios, the firm was rewarding luck as if it were skill.

The illusion of skill is not only an individual aberration; it is deeply ingrained in the culture of the industry.

He told me, with a trace of defensiveness, “I have done very well for the firm and no one can take that away from me.” I smiled and said nothing. But I thought, “Well, I took it away from you this morning. If your success was due mostly to chance, how much credit are you entitled to take for it?”

Cognitive illusions can be more stubborn than visual illusions.

As I had discovered from watching cadets on the obstacle field, subjective confidence of traders is a feeling, not a judgment.

Our understanding of cognitive ease and associative coherence locates subjective confidence firmly in System 1.

We know that people can maintain an unshakable faith in any proposition, however absurd, when they are sustained by a community of like-minded believers.

And we cannot suppress the powerful intuition that what makes sense in hindsight today was predictable yesterday.

Hitler, Stalin, and Mao Zedong. But there was a moment in time, just before an egg was fertilized, when there was a fifty-fifty chance that the embryo that became Hitler could have been a female. Compounding the three events, there was a probability of one-eighth of a twentieth century without any of the three great villains and it is impossible to argue that history would have been roughly the same in their absence. The fertilization of these three eggs had momentous consequences, and it makes a joke of the idea that long-term developments are predictable.

The results were devastating. The experts performed worse than they would have if they had simply assigned equal probabilities to each of the three potential outcomes. In other words, people who spend their time, and earn their living, studying a particular topic produce poorer predictions than dart-throwing monkeys who would have distributed their choices evenly over the options.

The reason is that the person who acquires

more knowledge develops an enhanced illusion of her skill and becomes unrealistically overconfident.

The more famous the forecaster, Tetlock discovered, the more flamboyant the forecasts.

They are dazzled by their own brilliance and hate to be wrong. Experts are led astray not by what they believe, but by how they think, says Tetlock.

“The Hedgehog and the Fox.”

The first lesson is that errors of prediction are inevitable because the world is unpredictable.

The second is that high subjective confidence is not to be trusted as an indicator of accuracy (low confidence could be more informative).

Clinical vs. Statistical Prediction: A Theoretical Analysis and a Review of the Evidence.

Meehl reviewed the results of 20 studies that had analyzed whether clinical predictions based on the subjective impressions of trained professionals were more accurate than statistical predictions made by combining a few scores or ratings according to a rule.

Ashenfelter converted that conventional knowledge into a statistical formula that predicts the price of a wine—for a particular property and at a particular age—by three features of the weather: the average temperature over the summer growing season, the amount of rain at harvest-time, and the total rainfall during the previous winter.

This new example of a “Meehl pattern” challenges the abilities of the experts whose opinions help shape the early price. It also challenges economic theory, according to which prices should reflect all the available

information, including the weather. Ashenfelter’s formula is extremely accurate—the correlation between his predictions and actual prices is above .90.

Why are experts inferior to algorithms? One reason, which Meehl suspected, is that experts try to be clever, think outside the box, and consider complex combinations of features in making their predictions. Complexity may work in the odd case, but more often tha...

Unreliable judgments cannot be valid predictors of anything.

The widespread inconsistency is probably due to the extreme context dependency of System 1. We know from studies of priming that unnoticed stimuli in our environment have a substantial influence on our thoughts and actions.

The brief pleasure of a cool breeze on a hot day may make you slightly more positive and optimistic about whateve...

Because you have little direct knowledge of what goes on in your mind, you will never know that you might have made a different judgment or reached a different decision under very slightly different circumstances.

Formulas do not suffer from such problems. Given the same input, they always return the same answer.

to maximize predictive accuracy, final decisions should be left to formulas, especially in low-validity environments.

Because interviewers are overconfident in their intuitions, they will assign too much weight to their personal impressions and too little weight to other sources of information, lowering validity.