Daniel Kahneman: Knowing When You Know Nothing About Finance

Dr. Daniel Kahneman, winner of the 2002 Nobel Prize in economics, joins us to discuss his book, Thinking, Fast and Slow. 

Studies show that even the highest-level economic leaders can't predict the future of, for instance, the S&P 500 (SNPINDEX: ^GSPC  ) -- but they think they can. In this video segment Daniel discusses a study on overconfidence in the financial industry. The full version of the interview can be watched hereA full transcript follows the video.

Morgan Housel: If we suffer from hindsight bias and we think that the past makes sense and was predictable, does that make us more optimistic about the future? If we think we understand the past, then we have to think we understand the future.

Daniel Kahneman: Oh, yeah. Oh, yeah, it makes us way overconfident about our knowledge of the future. Overconfidence is everywhere. If you are going to pick among the biases of judgment, then thinking that we know when we don't, that's a big one.

Thinking that we control things that we don't is another big one, so optimistic overconfidence accounts for a lot of the mistakes that are made.

In the financial context, there's a really frightening study that was published a couple of years ago. It shouldn't really surprise you, and maybe it won't, but here is the way it goes.

There is a study being conducted at Duke, I think, for many years now where they pick the CFOs of I think the biggest 500 companies, and they send them a questionnaire every year. It has a lot of questions, including forecasts.

One of the things that they're asked to forecast is they're asked to set an 80% confidence interval for the S&P 500 over the next 12 months. They have thousands of those judgments because many people come year after year.

In the first place, they have no idea what the S&P is going to do. The correlation is negative between their judgment and what actually happens. It's barely significant. It's nothing. They have no idea.

The thing that's worse is how overconfident they are. When you set an 80% confidence interval, if you are at least aware of how ignorant you are, and you do that many, many times, then 80% of the time the truth will fall inside your confidence interval and 20% of the time you'll be surprised.

In fact -- I'm pretty sure that I have that correct -- they have not 20% surprises. They have 67% surprises. They have no idea, and their confidence intervals are way too narrow.

Let me tell you where the true confidence interval ought to be for the S&P 500, because I asked the authors of that study to compute it. For somebody who has no idea, looking I think at the last decade or so -- that was not counting the last two years; I think I had the computation done in 2011 -- somebody who doesn't know anything about the S&P 500, and that's everybody, the correct confidence interval, there is a true answer to that.

The correct confidence interval that the S&P with 80% probability is going to grow between -10 and +30. What's striking about this is that this sounds you are saying nothing, and it is saying nothing because you know nothing.

That's what the confidence interval ought to be if you know nothing and you know that you know nothing. But those CFOs don't know it.

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