Thinking Fast and Slow

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larryswedroe
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Thinking Fast and Slow

Post by larryswedroe »

The book had been highly recommended to me, here are some of my thoughts

http://www.cbsnews.com/8301-505123_162- ... ColumnArea

Best wishes
Larry
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Re: Thinking Fast and Slow

Post by livesoft »

I am reading this book now. Kahneman touches on much more than loss aversion, risk taking and investing which are the aspects that Larry seemed to concentrate on his review. You will learn why poker players where dark glasses. You will learn to manipulate people subconsciously by 'priming' them ahead of time. You will see that Kahneman is even priming you as you read his book. Of course I am primed to highly recommended his book without reservation.
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Re: Thinking Fast and Slow

Post by jjustice »

I'm reading Kahneman's book, and I enthusiastically second Larry's recommendation. I regret that he shows the severe limitations of the adage that knowledge is power. Many cognitive biases and illusions are unavoidable even when we know about them. It's a humbling book.

John
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tadamsmar
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Re: Thinking Fast and Slow

Post by tadamsmar »

Larry's article provides good explanation of why NFL coaches don't use the best strategy for 4th down decisions, thereby losing an extra game per season on average according to statistical analysis. They fear getting blamed for the decision to go for it even when it provides the best expected pay off.
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Kahneman on the Kojo Nnamdi Show

Post by VictoriaF »

Kahneman was a guest on the Kojo Nnamdi Show on 29 Dec 2011. Here is a link to the podcast and transcript.

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GregLee
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Re: Thinking Fast and Slow

Post by GregLee »

I think I'm a little peculiar in fearing loss of future gains just as much as loss of present assets, if not more. That makes me especially skeptical of passive investing, since it involves giving up the potential gains one might make by beating the market.
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Re: Thinking Fast and Slow

Post by carolinaman »

Swedroe's article mentions how often doctor's expert diagnosis is wrong, about 40%. There is an excellent book on how often "experts" are wrong. It is entitled Wrong by David Freedman. It is well worth reading as well.
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Re: Thinking Fast and Slow

Post by GregLee »

johnep wrote:Swedroe's article mentions how often doctor's expert diagnosis is wrong, about 40%. There is an excellent book on how often "experts" are wrong. It is entitled Wrong by David Freedman. It is well worth reading as well.
I'll take a look at that. I follow some medical-health forums, and something that strikes me is another side of this: patients often seem unhappy with their doctors because the doctors' diagnoses are too full of skepticism and self-doubt. A dark spot shows up on a CT scan, and the patient wants to start chemotherapy to treat the tumor, but the doctor says wait, let's do another scan in 3 months and see if the spot changes -- maybe it's just an artifact of some sort on the scan. But the thought that they may have a tumor that will be growing, untreated, for months, tends to make patients a little crazy. So much to lose! The doctor can stand back and be skeptical about the results of the tests, but it's not his life at stake!

Freedman's web-blurb for his book is here: http://www.freedman.com/p/wrong-book.html.
Last edited by GregLee on Wed Jan 04, 2012 1:39 pm, edited 1 time in total.
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Re: Thinking Fast and Slow

Post by Liquid »

GregLee wrote:
johnep wrote:Swedroe's article mentions how often doctor's expert diagnosis is wrong, about 40%. There is an excellent book on how often "experts" are wrong. It is entitled Wrong by David Freedman. It is well worth reading as well.
I'll take a look at that. I follow some medical-health forums, and something that strikes me is another side of this: patients often seem unhappy with their doctors because the doctors' diagnoses are too full of skepticism and self-doubt. A dark spot shows up on a CT scan, and the patient wants to start chemotherapy to treat the tumor, but the doctor says wait, let's do another scan in 3 months and see if the spot changes -- maybe it's just an artifact of some sort on the scan. But the thought that they may have a tumor that will be growing, untreated, for months, tends to make patients a little crazy. So much to lose! The doctor can stand back and be skeptical about the results of the tests, but it's not his life at stake!
Vs surgery (may cause death), and chemotherapy/radiation (may cause cancer). Foolish doctors :roll:

Not to sidetrack thread, looks like an interesting book.
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Re: Thinking Fast and Slow

Post by tadamsmar »

GregLee wrote:I think I'm a little peculiar in fearing loss of future gains just as much as loss of present assets, if not more. That makes me especially skeptical of passive investing, since it involves giving up the potential gains one might make by beating the market.
What about avoiding the potential losses one might suffer by underperforming the market?

Simple math proves that on average these losses exceed the gains by the magnitude of the excess fees.
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Re: Thinking Fast and Slow

Post by magician »

jjustice wrote:Many cognitive biases and illusions are unavoidable even when we know about them.
I know an architect who discovered that he consistently underestimated the cost of jobs on which he bid by about 30%. Having determined that, for subsequent jobs he would develop the estimate, then increase it by about 40%. He found that he still underestimated the cost of jobs . . . by about 30%.
Simplify the complicated side; don't complify the simplicated side.
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Re: Thinking Fast and Slow

Post by GregLee »

tadamsmar wrote:Simple math proves that on average these losses exceed the gains by the magnitude of the excess fees.
No, I'm confident that math does not do that, though, I suppose, your claim might be true. It's not the sort of thing that could be demonstrated by a mathematical method.
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Re: Thinking Fast and Slow

Post by White Coat Investor »

Yes, the most interesting quote in Larry's column is the one about doctors. 40% when completely certain? I'm a little skeptical, but that's a really concerning number if it is true. Don't get me wrong, I'm uncertain about diagnosis A LOT (probably most of the time). But when I'm completely certain, there's no way I'm wrong 40% of the time.
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Re: Thinking Fast and Slow

Post by Rodc »

GregLee wrote:
tadamsmar wrote:Simple math proves that on average these losses exceed the gains by the magnitude of the excess fees.
No, I'm confident that math does not do that, though, I suppose, your claim might be true. It's not the sort of thing that could be demonstrated by a mathematical method.
With no fees the average dollar in the market gets the market average return (by definition).

With fees the average dollar invested earns less by exactly the average fee (transactions costs, er, etc.)

All you need is the definition of "average".

It is so simple that I would not use the word mathematical proof: is really is just a matter of definition.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: Thinking Fast and Slow

Post by tadamsmar »

GregLee wrote:
tadamsmar wrote:Simple math proves that on average these losses exceed the gains by the magnitude of the excess fees.
No, I'm confident that math does not do that, though, I suppose, your claim might be true. It's not the sort of thing that could be demonstrated by a mathematical method.
Bogle demonstrates it with elementary school math in one of his books.

All the invested dollars in the total stock market must get the average return before fees. Those invested dollars that are subject to higher fees and costs get a lower return after fees and costs on average.

This is perhaps the most rock solid argument for low-fee low-cost investing. And cap-weighted index fund investing in the total market minimizes management fees and turnover costs, so this provides the highest average return in a tax-deferred mutual fund account.
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Re: Thinking Fast and Slow

Post by GregLee »

tadamsmar wrote: All the invested dollars in the total stock market must get the average return before fees. Those invested dollars that are subject to higher fees and costs get a lower return after fees and costs on average.
I don't see any math going on, here. Nor, actually, any logic either, since the second sentence doesn't follow from anything -- it's pure assumption.
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JimInIllinois
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Re: Thinking Fast and Slow

Post by JimInIllinois »

tadamsmar wrote:
GregLee wrote:
tadamsmar wrote:Simple math proves that on average these losses exceed the gains by the magnitude of the excess fees.
No, I'm confident that math does not do that, though, I suppose, your claim might be true. It's not the sort of thing that could be demonstrated by a mathematical method.
Bogle demonstrates it with elementary school math in one of his books.

All the invested dollars in the total stock market must get the average return before fees. Those invested dollars that are subject to higher fees and costs get a lower return after fees and costs on average.
Logic tells you that the total return to all investors is the total return of all investable assets less all costs and fees. Therefore if through indexing you can guarantee average asset returns with below-average costs and fees you are assured of above-average returns as an investor. If whole-market indexers get above-average returns, then the asset-weighted average of all stock-pickers must be below the asset-weighted average of all investors.
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Re: Thinking Fast and Slow

Post by Fallible »

larryswedroe wrote:The book had been highly recommended to me, here are some of my thoughts

http://www.cbsnews.com/8301-505123_162- ... ColumnArea

Best wishes
Larry
I'm not quite a third of the way into Kahneman's book, but couldn't agree more with Larry that it's a "must read" on human behavior and investing. The interaction of the two systems of the mind, System 1 (fast, intuitive) and System 2 (slow, deliberate thought) is fasicinating. For example, Kahneman writes that, when #1 runs into difficulty, it calls on #2 "to support more detailed and specific processing that may solve the problem of the moment" and he goes into great detail on how the two work together. What I wonder at this early point in the book is whether the awareness it (and many other books on the brain and behavioral finance) brings to how we think and decide can actually change and improve our behavior or how much it can do so. As Larry notes, Kahneman "clearly shows that while we like to think of ourselves as rational in our decision making, the truth is we are subject to many biases. At least being aware of them will give you a better chance of avoiding them, or at least making fewer of them."

But only a "better chance"?
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Re: Thinking Fast and Slow

Post by TheEternalVortex »

Hofstadter's Law: It always takes longer than you expect, even when you take into account Hofstadter's Law.
Also see http://en.wikipedia.org/wiki/Bias_blind_spot
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Re: Thinking Fast and Slow

Post by larryswedroe »

emergency doc
Just provided us with another example of overconfidence (:-))

Seriously, the evidence is clear from many different studies (try reading Tetlock's Expert Political Judgment) that even when experts are highly confident they are wrong a lot of the time, not small percentages.


Also I completely agree with the recommendation on Wrong by Freedman. Can read my recommendationin my blog here


http://www.cbsnews.com/8301-505123_162- ... t%20wishes

Also Being Wrong is terrific book as well, by Kathryn Schulz


Larry
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Re: Thinking Fast and Slow

Post by happytrades »

I read the book, and it was slow going for me, although I am glad I made the effort. But there was an assertion in there about the average investor that seemed counter-intuitive to me. Kahneman says that the average investor loses money because he is unwilling to sell his winners and holds on to his losers (Chapter 32).

Do you agree with this assertion? Doesn't Efficient Market Hypothesis say that no one - over the long haul- can outsmart the market so that what you pick to buy or sell should not make much difference, should it?

And then there is this point about reversion to the mean and rebalancing. As good Bogleheads we are taught to rebalance, but if I am reading Kahneman correctly, he seems to be suggesting just the opposite.

Your thoughts?
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Re: Thinking Fast and Slow

Post by SGM »

Quick thinking causes us to easily see one angry face in a sea of happy faces as the quick brain is programmed for survival. The reverse, with a happy face in a sea of angry faces would not be noticed.

The Slow thinking brain acts as a brake on the Quick thinking side, but is often too lazy to do it's job correctly. Kahneman hopes that we will have conversations about how others make mistakes. He is less confident of finding his own mistakes. He knows too much about our irrational selves.
"Let us endeavor, so to live, that when we die, even the undertaker will be sorry." Mark Twain
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Re: Thinking Fast and Slow

Post by Rodc »

GregLee wrote:
tadamsmar wrote: All the invested dollars in the total stock market must get the average return before fees. Those invested dollars that are subject to higher fees and costs get a lower return after fees and costs on average.
I don't see any math going on, here. Nor, actually, any logic either, since the second sentence doesn't follow from anything -- it's pure assumption.
It is just by definition as I said above. Basic 8th grade arithmetic is all that is needed.

Perhaps if a "Nobel" prize winner explains it you will believe it:

http://www.stanford.edu/~wfsharpe/art/t ... esting.htm

See the section on active vs passive. Sharpe actually has a better little write up but I can't find it.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: Thinking Fast and Slow

Post by GregLee »

Rodc wrote:Perhaps if a "Nobel" prize winner explains it you will believe it:
No, that's not good enough. I read over part of the reference you give, and I find this:
The bottom line is that after costs, the average actively managed Euro (or dollar, or yen) must underperform the average passively managed Euro (or dollar, or yen) in a market. This is simple arithmetic.
And this seems to be saying what you say it says, so it's a relevant reference. Okay so far. My problem with it is that what Sharpe says is a lie. There is no arithmetic done in this piece that demonstrates the truth of the claim. Sharpe is claiming that to find returns one must subtract commissions and tax losses from the gains made through active management, and, as we know, subtraction is an arithmetic operation. I get that. But what is the actual result of the subtraction? What is subtracted from what to give what result? It's not here. A result does not count as being mathematically demonstrable simply because you claim that it follows by some mathematical operation.
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Re: Thinking Fast and Slow

Post by Rodc »

GregLee wrote:
Rodc wrote:Perhaps if a "Nobel" prize winner explains it you will believe it:
No, that's not good enough. I read over part of the reference you give, and I find this:
The bottom line is that after costs, the average actively managed Euro (or dollar, or yen) must underperform the average passively managed Euro (or dollar, or yen) in a market. This is simple arithmetic.
And this seems to be saying what you say it says, so it's a relevant reference. Okay so far. My problem with it is that what Sharpe says is a lie. There is no arithmetic done in this piece that demonstrates the truth of the claim. Sharpe is claiming that to find returns one must subtract commissions and tax losses from the gains made through active management, and, as we know, subtraction is an arithmetic operation. I get that. But what is the actual result of the subtraction? What is subtracted from what to give what result? It's not here. A result does not count as being mathematically demonstrable simply because you claim that it follows by some mathematical operation.
Just write it out for yourself if you need to see every detail. It will be instructive.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.
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Re: Thinking Fast and Slow

Post by tadamsmar »

GregLee wrote:
tadamsmar wrote: All the invested dollars in the total stock market must get the average return before fees. Those invested dollars that are subject to higher fees and costs get a lower return after fees and costs on average.
I don't see any math going on, here. Nor, actually, any logic either, since the second sentence doesn't follow from anything -- it's pure assumption.
Let's start with something very basic. Do you think everyone can beat the market or do you see that that must be impossible because the collection of all holdings is the market?

Beating the market is a zero sum game. If there are some winners, then there must be some compensating losers. Overall the active average investors tie the market return.

The passive investor simply invests in the whole market and gets exactly the whole market's return less fees/costs of 0.2%. He makes no attempt to beat the market.

The active investors attempt to beat the market, but as a group they also get exactly the whole market's return less 2%.

Since the average active investor has higher costs and fees, so he underperforms the passive investor by 1.8% per year.
Last edited by tadamsmar on Wed Jan 04, 2012 9:14 pm, edited 3 times in total.
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Re: Thinking Fast and Slow

Post by 555 »

GregLee wrote:
Rodc wrote:Perhaps if a "Nobel" prize winner explains it you will believe it:
No, that's not good enough. I read over part of the reference you give, and I find this:
The bottom line is that after costs, the average actively managed Euro (or dollar, or yen) must underperform the average passively managed Euro (or dollar, or yen) in a market. This is simple arithmetic.
And this seems to be saying what you say it says, so it's a relevant reference. Okay so far. My problem with it is that what Sharpe says is a lie. There is no arithmetic done in this piece that demonstrates the truth of the claim. Sharpe is claiming that to find returns one must subtract commissions and tax losses from the gains made through active management, and, as we know, subtraction is an arithmetic operation. I get that. But what is the actual result of the subtraction? What is subtracted from what to give what result? It's not here. A result does not count as being mathematically demonstrable simply because you claim that it follows by some mathematical operation.
What's the point of spelling it out in detail if someone who can't figure it out for themselves wouldn't understand it if it was spoonfed to them.
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Re: Thinking Fast and Slow

Post by umfundi »

magician wrote:
jjustice wrote:Many cognitive biases and illusions are unavoidable even when we know about them.
I know an architect who discovered that he consistently underestimated the cost of jobs on which he bid by about 30%. Having determined that, for subsequent jobs he would develop the estimate, then increase it by about 40%. He found that he still underestimated the cost of jobs . . . by about 30%.
That is actually a fact. The classic "The Mythical Man-Month" helps to understand it.

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Re: Thinking Fast and Slow

Post by GregLee »

tadamsmar wrote:Beating the market is a zero sum game. If there are some winners, then there must be some compensating losers. Overall the active average investors tie the market return.
Are you under the impression that your third sentence above somehow follows from the preceding?

Why be so shy about giving this supposed simple arithmetic demonstration in explicit form? We all know arithmetic here. Just give us the arithmetic.

Being an academic, I'm familiar with the technique of hand-waving, where at the most dubious points of his argument, the speaker tries to distract his audience by making intriguing motions in the air, thinking that listeners will let their opportunity to object pass by. That is what I see going on here. There is supposed to be some simple mathematical demonstration that passive investors will have superior returns because their costs are less. But every time I express skepticism about this, in lieu of an actual demonstration using actual arithmetic, I just get a blizzard of references and attempts to show that it must be possible to demonstrate it mathematically. If so, then just give the mathematical demonstration. Where's the math?
Last edited by GregLee on Wed Jan 04, 2012 10:26 pm, edited 2 times in total.
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Re: Thinking Fast and Slow

Post by kontango »

It's on my reading list. Daniel Kahneman is one of the pioneers in behavioral finance.
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Re: Thinking Fast and Slow

Post by 555 »

GregLee wrote:
tadamsmar wrote:Beating the market is a zero sum game. If there are some winners, then there must be some compensating losers. Overall the active average investors tie the market return.
Are you under the impression that your third sentence above somehow follows from the preceding?

Why be so shy about giving this supposed simple arithmetic demonstration in explicit form? We all know arithmetic here. Just give us the arithmetic.

Being an academic, I'm familiar with the technique of hand-waving, where at the most dubious points of his argument, the speaker tries to distract his audience by making intriguing motions in the air, thinking that listeners will let their opportunity to object pass by. That what I see going on here. There is supposed to some simple mathematical demonstration that passive investors will have superior returns because their costs are less. But every time I express skepticism about this, in lieu of an actual demonstration using actual arithmetic, I just get a blizzard of references and attempts to show that it must be possible to demonstrate it mathematically. If so, then just give the mathematical demonstration. Where's the math?
It's ironic that this thread is entitled "Thinking Fast and Slow"! :roll:
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Re: Thinking Fast and Slow

Post by kontango »

GregLee wrote:
tadamsmar wrote:Beating the market is a zero sum game. If there are some winners, then there must be some compensating losers. Overall the active average investors tie the market return.
Are you under the impression that your third sentence above somehow follows from the preceding?

Why be so shy about giving this supposed simple arithmetic demonstration in explicit form? We all know arithmetic here. Just give us the arithmetic.

Being an academic, I'm familiar with the technique of hand-waving, where at the most dubious points of his argument, the speaker tries to distract his audience by making intriguing motions in the air, thinking that listeners will let their opportunity to object pass by. That is what I see going on here. There is supposed to be some simple mathematical demonstration that passive investors will have superior returns because their costs are less. But every time I express skepticism about this, in lieu of an actual demonstration using actual arithmetic, I just get a blizzard of references and attempts to show that it must be possible to demonstrate it mathematically. If so, then just give the mathematical demonstration. Where's the math?
No math is necessary. It's just boring arithmetic. Nothing more.

Suppose everyone here in Bogleland represents the entire universe of active money managers (I know, that's an anathema, but suppose it's true). They spend a lot of money doing research on stocks. By definition, they hold the market (since they are the universe). Suppose the weighted average return for the universe of active managers is 10%.

Now, suppose you are a passive investor. You simply buy the universe of stocks owned by all active managers. That is, you also own the market...you hold what all active managers hold and in the same proportions. Your average return must be 10%. The only difference is you did no research and paid no costs for research whereas the active managers did. Therefore, your return must be the same as active managers, minus the differences in fees/expenses. So, on that basis you will outperform.

What is powerful about this argument is that it doesn't matter how you define "market." Suppose you are interested in investing in, say, all small-cap internet stocks. All you have to do is buy the universe of stocks held by small-cap internet stock funds (in the same proportion) and you will have the same gross return as the average active manager. However, you will outperform the average active managers after fees because you paid low fees whereas active managers have large expenses.

It's a powerful argument and it does not depend on market efficiency. It's true whether markets are efficient are not!

It's all about averages. No math required.
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Re: Thinking Fast and Slow

Post by JimInIllinois »

GregLee wrote:
tadamsmar wrote:Beating the market is a zero sum game. If there are some winners, then there must be some compensating losers. Overall the active average investors tie the market return.
Are you under the impression that your third sentence above somehow follows from the preceding?

Why be so shy about giving this supposed simple arithmetic demonstration in explicit form? We all know arithmetic here. Just give us the arithmetic.

Being an academic, I'm familiar with the technique of hand-waving, where at the most dubious points of his argument, the speaker tries to distract his audience by making intriguing motions in the air, thinking that listeners will let their opportunity to object pass by. That what I see going on here. There is supposed to some simple mathematical demonstration that passive investors will have superior returns because their costs are less. But every time I express skepticism about this, in lieu of an actual demonstration using actual arithmetic, I just get a blizzard of references and attempts to show that it must be possible to demonstrate it mathematically. If so, then just give the mathematical demonstration. Where's the math?
OK, let m_i be the market capitalization of the ith stock in the S&P 500 index at the beginning of a year and r_i it's fractional return (e.g., 10%=0.1) for that year. Let M = sum of m_i, the total market capitalization of the all stocks in the index. The market returns the sum of m_i * r_i, which when divided by M is the fractional market return R. Suppose fraction a of M is owned by investors in index funds that incur fractional expenses f, leaving fraction (1-a) owned by other investors who incur expenses F. The index fund owns all stocks in proportional to their market capitalization, i.e., for each stock i the index fund owns a * m_i. The remaining (1-a) * m_i must be owned by other non-index investors. The return before expenses to the index investors is the sum of a * m_i * r_i, which is equal to a * the sum of m_i * r_i. Dividing by a * M gives R, demonstrating that before expenses the index fund investors obtain the market return R. Substituting 1-a for a in the above shows that the non-index investors as a whole similarly obtain the market return R (they own 1-a of the shares and receive 1-a of the returns). After fees, the index investors as a whole obtain a net return of R-f and the non-index investors obtain a net return of R-F. Each index investor obtains the same return R-f because they all own the same stocks in the same proportion. The distribution of returns among the non-index investors depends on their stock picks, but their collective gains divided by their collective investment less expenses is still R-F. Thus the difference in average returns between the index and non-index investors is (R-f) - (R-F) = F-f, the difference in expenses.
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Re: Thinking Fast and Slow

Post by Rick Ferri »

I've been "slowly" reading the book over the past month (512 pages, small print, few pictures). It is a very interesting book that is taking some time to absorb, and it is scary in some ways. Do I really think this way? No, not me...I don't have those biases...do I? OTHER people think that way...it's obvious...but not me! Yikes! :shock:

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Re: Thinking Fast and Slow

Post by JimInIllinois »

kontango wrote:It's a powerful argument and it does not depend on market efficiency. It's true whether markets are efficient are not!
Excellent point. Once you know you can do better than average by low-cost indexing, the question remaining is what are your expected returns from some alternate stock-picking strategy. If you have sufficiently above-average skill to overcome your research and trading costs then you should pick stocks, but the tiny number of people who appear to have that skill is consistent with random chance. The only way the skilled stock-pickers can make money long-term is off of a well-funded group of consistently unskilled or unlucky stock-pickers. High-income retail investors being churned by their brokers used to fit that description, then the dot com day-traders, but in today's market I'm not sure who the "dumb money" is supposed to be or how much of it is left.
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Re: Thinking Fast and Slow

Post by GregLee »

kontango wrote: No math is necessary. It's just boring arithmetic. Nothing more.
... Suppose the weighted average return for the universe of active managers is 10%.
... Your average return must be 10%.
Arithmetic is math. I can't find the arithmetic in what you've written. They get 10%, I'm like them, so I get 10%, too. Is this arithmetic?
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kontango
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Re: Thinking Fast and Slow

Post by kontango »

GregLee wrote:
kontango wrote: No math is necessary. It's just boring arithmetic. Nothing more.
... Suppose the weighted average return for the universe of active managers is 10%.
... Your average return must be 10%.
Arithmetic is math. I can't find the arithmetic in what you've written. They get 10%, I'm like them, so I get 10%, too. Is this arithmetic?
True enough, arithmetic is math. The math is a weighted average. You, as a passive investor, get the value-weighted average of the active investors minus the difference in fees/costs.
JimInIllinois
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Re: Thinking Fast and Slow

Post by JimInIllinois »

GregLee wrote:
kontango wrote: No math is necessary. It's just boring arithmetic. Nothing more.
... Suppose the weighted average return for the universe of active managers is 10%.
... Your average return must be 10%.
Arithmetic is math. I can't find the arithmetic in what you've written. They get 10%, I'm like them, so I get 10%, too. Is this arithmetic?
Arithmetic is math, but most math is not arithmetic. Arithmetic lets you balance your checkbook and do your taxes. Math allows you to logically deduce properties of systems that hold under a wide variety of cases. For example, on the earth's equator there is at any time at least one pair of diametrically opposed points with the same temperature.

In this case, it's hopefully obvious that any market-cap-weighted set of assets will provide a market-cap-weighted return that is equal to the market-cap-weighted return of the entire market. The insight is that if you remove a market-cap-weighted portion of the market from active management, the remaining actively managed portion is also market-cap-weighted, so the set of all actively managed assets also provides the market return, just with higher expenses and a variety of results for the individual managers.
555
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Re: Thinking Fast and Slow

Post by 555 »

GregLee wrote:
tadamsmar wrote:Beating the market is a zero sum game. If there are some winners, then there must be some compensating losers. Overall the active average investors tie the market return.
Are you under the impression that your third sentence above somehow follows from the preceding?

Why be so shy about giving this supposed simple arithmetic demonstration in explicit form? We all know arithmetic here. Just give us the arithmetic.

Being an academic, I'm familiar with the technique of hand-waving, where at the most dubious points of his argument, the speaker tries to distract his audience by making intriguing motions in the air, thinking that listeners will let their opportunity to object pass by. That is what I see going on here. There is supposed to be some simple mathematical demonstration that passive investors will have superior returns because their costs are less. But every time I express skepticism about this, in lieu of an actual demonstration using actual arithmetic, I just get a blizzard of references and attempts to show that it must be possible to demonstrate it mathematically. If so, then just give the mathematical demonstration. Where's the math?
What branch of academia are you in?
Why did you characterize this as "hand-waving"?
Now that you've goaded some people into patiently explaining a genuinely trivial mathematical fact, do you understand the explanation?
Do you understand why people often legitimately omit the details of routine and straightforward arguments?
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GregLee
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Re: Thinking Fast and Slow

Post by GregLee »

JimInIllinois wrote:The index fund owns all stocks in proportional to their market capitalization, i.e., for each stock i the index fund owns a * m_i. The remaining (1-a) * m_i must be owned by other non-index investors.
I don't see how that follows. There could be stocks held only by the index fund and not held by any non-index investor. (That's important, because the non-index investors could have insider information that some companies will go broke and so refuse to buy any of their stocks.)
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dumbmoney
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Re: Thinking Fast and Slow

Post by dumbmoney »

Good book. Lots of applications to the psychology of investing. For example, people flip between risk averse and risk seeking depending on whether the safer choice is arbitrarily defined as a loss.

It's hard work to be rational. We aren't Vulcans.
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GregLee
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Re: Thinking Fast and Slow

Post by GregLee »

555 wrote: What branch of academia are you in?
Why did you characterize this as "hand-waving"?
Now that you've goaded some people into patiently explaining a genuinely trivial mathematical fact, do you understand the explanation?
Do you understand why people often legitimately omit the details of routine and straightforward arguments?
Before I retired, I was a linguist.
I explained above why it's hand-waving.
No, I don't understand the explanation.
No, I don't understand the legitimacy of omitting supposedly routine arguments, when conclusions are challenged.
Greg, retired 8/10.
LAbob
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Re: Thinking Fast and Slow

Post by LAbob »

I'm about half way through the book. One fascinating System 1 analysis concerns a medical test. His analysis is of a disease in which 1 of every 600 patients sent for a test have the particular disease, and the test issues a false positive only once every 25 times. While you would be pretty upset if a test that accurate came back positive (your "system 1" response), the positive result actually decreases the odds by 4%, if I understand it correctly. There is a 1/600 chance a person sent for the test has the disease; i.e., a 0.166% chance. A positive test result has a 24/25 chance of being correct; i.e., 96%. So the patient actually goes from 0.166% of having the disease to a 0.160% chance of having it (0.0017 x .96) which is a negative 4% change and not so scary. Very counter-intuitive!!
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Re: Thinking Fast and Slow

Post by Bongleur »

>Now, suppose you are a passive investor. You simply buy the universe of stocks owned by all active managers. That is, you also own the market...you hold what all active managers hold and in the same proportions. Your average return must be 10%.
>

No. You cannot buy their universe. They don't publish what they are buying in real time. You can only buy what they bought some time in the past, and your price, risk, everything, will be different.
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Re: Thinking Fast and Slow

Post by tadamsmar »

GregLee wrote:
JimInIllinois wrote:The index fund owns all stocks in proportional to their market capitalization, i.e., for each stock i the index fund owns a * m_i. The remaining (1-a) * m_i must be owned by other non-index investors.
I don't see how that follows. There could be stocks held only by the index fund and not held by any non-index investor. (That's important, because the non-index investors could have insider information that some companies will go broke and so refuse to buy any of their stocks.)
There can not be a stock not held by any non-index investor, because the index investors hold stocks in proportion to the market. If index investors as a group hold 10% of the total stock market then they hold only 10% of each stock that makes up the market. 90% of the stock in every company must be held by non-index investors.

If that is your only objection to JimInIllinois derivation, then perhaps you will now understand what we are trying to explain.
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Re: Thinking Fast and Slow

Post by GregLee »

tadamsmar wrote:There can not be a stock not held by any non-index investor, because the index investors hold stocks in proportion to the market.
If the non-index investors decide to sell all their stocks in the Bound-to-Fail corporation, why can't they do that? Is there a law? If the consequence is that your "because" condition is not met, that's your problem. You didn't show that it is always possible for index investors to "hold stocks in proportion to the market."
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kontango
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Re: Thinking Fast and Slow

Post by kontango »

GregLee wrote:
tadamsmar wrote:There can not be a stock not held by any non-index investor, because the index investors hold stocks in proportion to the market.
If the non-index investors decide to sell all their stocks in the Bound-to-Fail corporation, why can't they do that? Is there a law? If the consequence is that your "because" condition is not met, that's your problem. You didn't show that it is always possible for index investors to "hold stocks in proportion to the market."
First we are confusing "index portfolio" with a passive market portfolio. An index portfolio is a proxy for a passive market portfolio (the portfolio of all stocks held according to their market weights). The market portfolio is the ideal and is what passive index portfolios try to emulate.

It is impossible for a passive market portfolio to have stocks that active investors do not have. This is why it is impossible for the average return for active mangers to exceed that of the market. The average alpha must be zero before fees/expenses!

What about stock indexes (think Vanguard's Total Stock Market Index or S&P 500 funds)? The issue is whether the index is a representative sample of the market or not. If yes, then the logic above follows (average alpha for active managers is zero, before expenses). If not, then that is the problem of the costruction or execution of the index, not the prowess of active managers.
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Re: Thinking Fast and Slow

Post by tadamsmar »

The non-index investors are trading among themselves. The investor who is merely holding shares in a total market index fund is not trading.
GregLee wrote: If the non-index investors decide to sell all their stocks in the Bound-to-Fail corporation, why can't they do that?
Greg, surely you know that you cannot sell something if you don't have a buyer. In order to sell a stock there must be a buy order. It's possible for there to be no buy order, but rare. Typically there will be a buy order from a trader. But, obviously, there will be no buy orders from those who are merely holding shares and not trading.
Is there a law?
The is no law that says a trader cannot sell. There is just a queue of buy orders that may or may not be empty. There is no law that says there is a buy order on the queue as has been demonstrated by market flash crashes of the past. (In fact, the computers were providing buy orders of a fraction of a cent during the flash crash, but these trades were reversed after the fact.)
If the consequence is that your "because" condition is not met, that's your problem. You didn't show that it is always possible for index investors to "hold stocks in proportion to the market."
I am not sure what you mean by my "because" condition.

BTW, you seem to be shifting to a new line of argument, saying that index investing is impossible or at least impossible to execute with perfection. Does that mean that at long last you finally understand that index investors have an advantage over active traders in proportion to the fees and costs - before you were claiming that that could not be proven via a simple mathematical word problem.
Last edited by tadamsmar on Thu Jan 05, 2012 8:09 am, edited 2 times in total.
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tadamsmar
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Re: Thinking Fast and Slow

Post by tadamsmar »

kontango wrote:
GregLee wrote:
tadamsmar wrote:There can not be a stock not held by any non-index investor, because the index investors hold stocks in proportion to the market.
If the non-index investors decide to sell all their stocks in the Bound-to-Fail corporation, why can't they do that? Is there a law? If the consequence is that your "because" condition is not met, that's your problem. You didn't show that it is always possible for index investors to "hold stocks in proportion to the market."
First we are confusing "index portfolio" with a passive market portfolio. An index portfolio is a proxy for a passive market portfolio (the portfolio of all stocks held according to their market weights). The market portfolio is the ideal and is what passive index portfolios try to emulate.

It is impossible for a passive market portfolio to have stocks that active investors do not have. This is why it is impossible for the average return for active mangers to exceed that of the market. The average alpha must be zero before fees/expenses!

What about stock indexes (think Vanguard's Total Stock Market Index or S&P 500 funds)? The issue is whether the index is a representative sample of the market or not. If yes, then the logic above follows (average alpha for active managers is zero, before expenses). If not, then that is the problem of the costruction or execution of the index, not the prowess of active managers.
I am just not getting into the messy details of engineering an index that is a proxy for the total market, and this is not due to confusion on my part. These details are not important when providng a mathematical proof of the fact that the averge performance of total market index fund holders is higher than the average performance of active traders of the stocks that compose the market. The details have a relatively minor impact on these averages as compared with the relative 1-2% per year performance headwind that the active traders encounters due to fees and cost.
kontango
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Re: Thinking Fast and Slow

Post by kontango »

tadamsmar wrote:
kontango wrote:
GregLee wrote:
tadamsmar wrote:There can not be a stock not held by any non-index investor, because the index investors hold stocks in proportion to the market.
If the non-index investors decide to sell all their stocks in the Bound-to-Fail corporation, why can't they do that? Is there a law? If the consequence is that your "because" condition is not met, that's your problem. You didn't show that it is always possible for index investors to "hold stocks in proportion to the market."
First we are confusing "index portfolio" with a passive market portfolio. An index portfolio is a proxy for a passive market portfolio (the portfolio of all stocks held according to their market weights). The market portfolio is the ideal and is what passive index portfolios try to emulate.

It is impossible for a passive market portfolio to have stocks that active investors do not have. This is why it is impossible for the average return for active mangers to exceed that of the market. The average alpha must be zero before fees/expenses!

What about stock indexes (think Vanguard's Total Stock Market Index or S&P 500 funds)? The issue is whether the index is a representative sample of the market or not. If yes, then the logic above follows (average alpha for active managers is zero, before expenses). If not, then that is the problem of the costruction or execution of the index, not the prowess of active managers.
I am just not getting into the messy details of engineering an index that is a proxy for the total market, and this is not due to confusion on my part. These details are not important when providng a mathematical proof of the fact that the averge performance of total market index fund holders is higher than the average performance of active traders of the stocks that compose the market. The details have a relatively minor impact on these averages as compared with the relative 1-2% per year performance headwind that the active traders encounters due to fees and cost.
I don't think I am disagreeing with you. I was responding to GregLee.
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