Discover Daniel Kahneman’s “illusion of skill.” Learn why highly paid Wall Street fund managers fail to beat the market and why index funds are better for your FIRE journey.
Introduction
Over the last two posts, we explored how our brains are naturally wired to make bad investment decisions. We learned [how the emotional “System 1” brain makes us buy terrible stocks] (← 1편 URL 링크) because of FOMO, and [how “myopic loss aversion” destroys our wealth] (← 2편 URL 링크) when we check our stock apps every day.
By now, you might be feeling a bit discouraged. If our own brains are our worst enemies, what should we do? Should we give our money to highly educated, highly paid Wall Street experts and fund managers? They wear nice suits, appear on financial TV shows, and use complex mathematical models. Surely, they know how to beat the market, right?
Today, we are going to look at the shocking truth about the financial industry. Using the brilliant research of Nobel laureate Daniel Kahneman, we will uncover the “Illusion of Skill” and learn why the best thing you can do for your FIRE (Financial Independence, Retire Early) journey is to stop trusting the experts.
The Illusion of Skill on Wall Street
In his masterpiece book Thinking, Fast and Slow, Daniel Kahneman tells a fascinating story about a visit he made to a large Wall Street investment firm. The executives at this firm gave Kahneman a spreadsheet containing the investment results of 25 anonymous wealth advisers over eight consecutive years.
Kahneman wanted to see if these highly paid professionals actually had a special skill for picking winning stocks. To do this, he looked for a statistical correlation. If an adviser was highly skilled, they should perform well year after year. The winners in Year 1 should also be the winners in Year 2, Year 3, and so on.
What did Kahneman find? The correlation from year to year was exactly zero.
The results of these highly trained advisers were no better than rolling dice or tossing a coin. The person who had the best return in Year 1 might have the worst return in Year 2. There was no consistency. Their success was entirely based on luck, not skill.
But here is the most terrifying part of the story. When Kahneman presented these facts to the executives of the firm, expecting them to be shocked, they simply smiled and ignored the data. They continued to pay massive bonuses to the “top” performers of the year, pretending that luck was actually a skill.
Kahneman calls this the “Illusion of Skill” and the “Illusion of Validity.” The financial industry is built on a massive illusion. Fund managers and TV experts genuinely believe they have a special ability to predict the unpredictable stock market. But mathematically, they do not.
Are You Smarter Than the Experts?
If professional fund managers who spend 80 hours a week analyzing stocks cannot beat a coin toss, what about individual investors like you and me?
A famous researcher named Terry Odean studied the trading records of 10,000 individual brokerage accounts over a seven-year period. He looked at every stock these investors sold and every stock they bought. Naturally, an investor sells a stock because they think it will go down, and they buy a new stock because they think it will go up.
Odean found something hilarious and sad. On average, the stocks that the investors sold actually performed better than the new stocks they bought!
Why does this happen? Kahneman explains that it is because of “overconfidence.” We watch a few YouTube videos, read a few news articles, and suddenly we think we know something that the rest of the market does not know. We jump to conclusions based on very little evidence. Odean and his colleague Brad Barber titled one of their most famous research papers: Trading Is Hazardous to Your Wealth. The more frequently people traded stocks, the worse their returns became.
The High Cost of the Illusion
You might think, “Well, even if the fund managers are just guessing, at least they are trying. What is the harm in letting an expert manage my money?”
The harm is in the fees.
Benjamin Graham, the father of value investing, constantly warned investors about the high costs of Wall Street. A typical active mutual fund charges you an annual management fee of 1% to 2%. They charge you this fee whether they make money or lose money.
Let’s do some simple math. If the stock market historically grows at an average of 10% a year, and your fund manager takes 2% in fees, they are stealing 20% of your total growth every single year. Because we know that these managers cannot consistently beat the market, paying them a high fee is a guaranteed way to destroy the magic of compound interest. Over 20 or 30 years, those “small” 2% fees will eat up hundreds of thousands of dollars of your retirement money.
Conclusion: The Beautiful “Dumb” Index Fund
So, if we cannot trust our own brains to pick stocks, and we cannot trust the highly paid Wall Street experts, how on earth do we achieve Financial Independence and Retire Early?
The answer is beautiful in its simplicity. Stop trying to beat the market. Stop paying for the illusion of skill. Instead, just buy the entire market.
This is why FIRE investors love [building a core portfolio with low-cost Index Funds, like the S&P 500 ETF]. An S&P 500 ETF simply buys a tiny piece of the 500 largest companies in America. There is no highly paid manager trying to guess which stock will go up tomorrow. It runs automatically. Because there is no “expert” to pay, the fees are incredibly low—often less than 0.05% a year.
When you buy a broad ETF, you accept reality. You admit that you cannot predict the future. You admit that nobody on TV can predict the future. You simply trust that over the next 10, 20, or 30 years, human innovation and the global economy will continue to grow.
Investing should not be an exciting game of guessing and gambling. It should be a boring, mechanical process. Overcome your overconfidence, ignore the illusion of skill, buy low-cost ETFs, and use your free time to actually enjoy your life.
This concludes our 3-part series on the behavioral economics of investing. I hope Kahneman’s insights help you protect your mind and your wallet. Stay tuned for our next FIRE topic!