Friday, December 20, 2013

Luck or Skill? (TFS, part 9)

I am reading Thinking, Fast and Slow, by Daniel Kahneman. In this series I will summarize key parts of the book and supply some comments and reflections on the material.

Part III: Overconfidence
Chapters 19-20


Halo effect, hindsight bias, outcome bias, illusion of validity, illusion of skill (thinking an outcome is a result of mostly skill when the outcome is a result of mostly luck).

Errors of prediction are inevitable because the world is unpredictable.  High subjective confidence is not to be trusted as an indicator of accuracy (someone admitting low confidence could be much more informative).

My Thoughts:

One thing Kahneman complains quite a bit about is how much some people get paid when it seems like their job is mostly -- he stops just short of explicitly saying all -- luck. He calls out stock traders and CEOs specifically, and questions why incentive pay exists at all if it's almost all luck.

I think Kahneman goes too far. For example, I don't think Microsoft's stock price wouldn't have jumped so much at the announcement of the retirement of a lackluster CEO if CEOs don't matter.

In one calculation, Kahneman looks at investment results for 25 investment advisers in one firm over 8 years and finds basically 0 average correlation in the relative rank of the advisers across every pair of years (I am not sure looking at every pair of years and averaging to get an overall correlation is a good idea, but whatever). He concludes from the zero correlation that their job is "mostly chance" and the firm was rewarding employees based on "luck rather than skill," so why pay bonuses? It's very easy to imagine that without the bonuses advisers would have worked less hard for the firm and all achieved worse results on their investments or brought in fewer clients, or whatever, to the detriment of the firm. The bonuses serve a very useful purpose of encouraging harder work. The zero correlation in rank of the employees over time does not necessarily mean the bonuses were serving no purpose as Kahneman seems to think.

Food for Thought:

1) "You should have known the market was going to crash!"

2)  "We had access to all the information we needed. Why didn't the government connect the dots to prevent 9/11?"

3) Why do people trade stocks at all? (No Trade Theorem)

4) An engineering firm hires a new class of employees with exactly the same credentials from a good college. The firm cares about producing patents. The ability of employees to come up with patentable ideas is a function of their credentials, hard work/effort, and a lot of luck. The firm cannot observe effort or luck. Employees decide how much effort to put into their job.
    a) Will the firm produce more patents if it pays bonuses based on the number of patents rather than a flat wage?
    b) Will the distribution of income among employees with identical credentials be more unequal if bonuses are paid out?
    c) Alice received a $10,000 bonus this year. Bob received no bonus. True or False: We know for sure that Alice worked harder than Bob this year.
    d) Suppose all employees choose to exert the same amount of effort under the incentive pay system. The difference in patents (and pay) among employees at the end of the year is thus entirely due to luck. Does that mean the incentive pay system is serving no useful purpose? What if it was known that income will be redistributed by the government at the end of the year to make everyone's pay equal. Pay differences are due to luck, after all. Would employees produce as many patents?
    d) Suppose more firms move to incentive pay rather than flat wages causing inequality in the whole country to increase. Is this a good thing? Is it fair?

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