Are you paying for useless advice?

False experts, the “Hot-Hand Fallacy”, and the “Law of Small Numbers.”

Can people be fooled into believing in a non-existent expert? If so, will they then pay for what can only be described as useless advice about future chance events? The answer is yes, and this type of misjudgment is both costly and pervasive.

Why do otherwise rational people irrationally pay for advice about what will happen in the future, when future events are mostly random? What explains the large sums of money spent in the finance industry on people who appear to be nothing more than fortune-tellers, time-travelers, or some other type of false-expert?

Economists and Psychologists weigh in

Traditional economists attribute such behaviors to errors in decision-making. They claim that a rational person is not likely to commit such an error, and that most people will pay for advice only if it does not seem useless at the time of purchase, but later turns out to be useless.

But behavioral economists, who study the decision-making behavior of average people, disagree strongly. They agree that most people are rational, but when it comes to decision-making under conditions of uncertainty (likely outcomes are unknown), they often behave irrationally.

In contrast to traditional economists, psychologists argue that human beings are hypersensitive in detecting agency, even when none exists. This helps them to explain phenomena that cannot be easily explained. The implication is that people will be happy to pay for advice that might seem to conflict with their objective reasoning, if they believe there is an intelligent agent, who knows things that they don’t, and is acting in their best interest. Such an apparent divide between the two social-science disciplines is interesting, to say the least.

Psychologists have a general model to explain the prevalence of humans’ belief in invisible agents or non-existent expertise. The psychologist Justin Barrett (2004) hypothesizes that, in order to survive and reproduce, humans have evolved to be hypersensitive to detecting agency, even when there is none. For our ancient ancestors, it was far better to avoid several imaginary predators than be eaten by a real one.

According to this hypersensitive agency detection device (or HADD) hypothesis, HADD is set off by various ambiguous environmental signals, such as recent observations of good or bad streaks of chance events, and when triggered, HADD produces beliefs in unseen agents who are presumed to be the cause of these ambiguous signals, such as spirits or supernatural agents.

Consider a situation where there is true randomness of possible outcomes, and predictions are demonstrably useless. A coin toss, a scratch-off lottery ticket, or a roulette wheel for example. In these realms of random outcomes and non-existent expertise, can an average individual be convinced to switch from having the (correct) belief that “outcomes are independent and predictions are inherently useless”, to the (false) belief that “predictions provide useful information about the future”– thus leading them to pay for such predictions?

The answer is yes – if they had recently observed a streak of accurate predictions being made in front of them, and in real time. In the land of the false expert, the size of the errors made by people is quite large.

The Law of Small Numbers

Believers of “the law of small numbers” – that a small sample of observations represents the parent population from which it is drawn (Kahneman & Tversky, 1971) – will be willing to pay for services by so-called financial experts after observing randomly occurring streaks of correct predictions made by these experts.

This fallacious belief in the hot-hand of a financial expert arises as a consequence of the gambler’s fallacy, which is defined as an individual’s tendency to expect outcomes in random sequences to exhibit systematic streaks followed by systematic reversals. For example, roulette players will frequently keep track of which numbers have come up, and then bet on the ones that haven’t come up for a long time and are therefore “overdue.”

Similarly, an investor who believes that the performance of a mutual fund is due to the portfolio manager’s ability to predict which stocks will rise and which will fall in the future will, at first, underestimate the likelihood that a manager of average ability will exhibit a streak of above-average performance.

Following a streak of good performance, however, the investor will revert to overestimate the likelihood that the manager is above average, and so in turn will over-infer that the streak of unusual performance will continue.

The implication of this is that believers of the law of small numbers will be happy to pay for future price predictions provided by experts, such as stockbrokers or managers of actively-managed funds, even when it is well-documented that actively-managed funds do not outperform their market benchmark on average (Eugene Fama, 1991).

Conclusions

We began by noting a divide between the economic and psychological explanations of people paying for demonstrably useless advice. Traditional economics assumes that most people are rational, most of the time. This is correct, because in order to navigate a highly complex world like ours, rationality is an essential skill.

But nobody can know everything about how the world works in every realm of activity. So we turn to experts for advice or hire them to manage things on our behalf. This is perfectly rational behavior.

I, for example, don’t know anything about cars or how to fix problems when they arise. So I (rationally) farm that task out to an expert. I do a rigorous round of due diligence before I choose which expert to hire, as do most people. But there’s a limit to how much I would be willing to pay the expert on the spot. At some point, I would walk away and get a second opinion.

When it comes to investing our life savings, things are very different. Unless you happen to have the time and motivation to “tinker” with your investments on a DIY basis, it makes perfect sense to farm this task out to an expert. Due diligence is the key to this process.

Problems arise when suspend our rationality and succumb to magical thinking at critical moments like this. Investors who turn their money over to the care and custody of experts are doing so because they believe that the expert knows what will happen in the future. But they don’t. And they can’t, unless they have a true edge such as insider information.

If you agree to pay an expert adviser a 1% fee to make investment decisions for you, what are you really getting in return? That 1% fee seems inconsequential at first, and the adviser will probably emphasize that point during his or her sales pitch. But over the long term, it will cost you as much as half of your retirement nest egg.

Here’s what I tell advisers after they finish their dog-and-pony show. (About every two years, I hire recent college graduates to pose as secret shoppers. They present a hypothetical portfolio to the adviser, and ask what the adviser would do for them.) I would make a counter-offer to their 1% fee proposal (or whatever it was).

I would offer to pay them 10% instead of 1%. Does that sound irrational to you? It probably does, until you consider that I attach one simple and rational condition to the offer. I would only pay the 10% fee on the excess return they delivered, above the relevant benchmark index. I have yet to find any takers.

These results seem to be more consistent with the predictions made by the discovery of the gambler’s and hot-hand fallacies in the economics literature and the psychological concept of invisible agents, and away from the traditional economist’s model of random error in the decision-making process.