I put off reading this book because I thought that I would already know most of its contents.  I was wrong.  Really wrong.

There is a review with a more statistical orientation on the Burns Statistics site.  Here the focus is towards economics.  The topics that  most directly impinge on fund management are:

• prospect theory versus utility theory
• the illusion of skill
• risk-benefit illusions
• Econs versus Humans

Prospect theory

Utility theory says that people make decisions based on optimizing their utility.  Nice theory; it makes sense.  The problem is that it isn’t what people actually do.

Utility theory presumes a global optimization.  We actually do a local optimization around some state (because we are lazy and have limited computational power).

The key things that prospect theory highlight are:

• we compare to a state of the world (often the status quo)
• in those comparisons losses are much worse than gains
• there are diminishing effects as either gains or losses increase

Maximum drawdown is horrifically poor from a statistical point of view.  Prospect theory gives another reason to avoid it.

Maximum drawdown puts the focus on the highest value achieved.  With this frame losses occur almost continuously.  In contrast if the anchor is the value at a particular time (start of year, for example), then even a coin flip will tend to have losses only about half the time.

See the decision weights section of the Burns Statistics review for more on risk aversion and such.

Illusion of skill

We have a drive to create stories of our experience that minimize the role of chance.  We are very biased towards attributing investment gains to our skill.  Furthermore we are good at ignoring that illusion even if we understand it intellectually.

For practical fund management I think the counterbalance is to emphasize to yourself how much you don’t know and how random results are.

Risk-benefit

The risk-benefit illusion goes like this:

• if I decide I like something, then I think it has a lot of benefit and little risk
• if I decide I don’t like something, then I think it has little benefit and a lot of risk

We seem to be incapable of thinking that something has both a lot of benefit and a lot of risk.

The lesson, I think, is that doing risk-benefit analyses is a whole lot trickier than expected.

Econs

Econs are the hypothetical beings studied by traditional economics that are always rational, never change their desires, and know all the necessary information.  There might be some questionable results when the human economy is modeled using the behavior of Econs.

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