People are continually enticed by such “hot” performance, even if it lasts for brief periods. Because of this susceptibility, brokers or analysts who have had one or two stocks move up sharply, or technicians who call one turn correctly, are believed to have established a credible record and can readily find market followings. Likewise, an advisory service that is right for a brief time can beat its drums loudly. Elaine Garzarelli gained near immortality when she purportedly “called” the 1987 crash. Although, as the market strategist for Shearson Lehman, her forecast was never published in a research report, nor indeed communicated to its clients, she still received widespread recognition and publicity for this call, which was made in a short TV interview on CNBC. Still, her remark on CNBC that the Dow could drop sharply from its then 5300 level rocked an already  nervous market on July 23, 1996. What had been a 40-point gain for the Dow turned into a 40-point loss, a good deal of which was attributed to her comments.

The truth is, market-letter writers have been wrong in their judgments far more often than they would like to remember. However, advisors understand that the public considers short-term results meaningful when they are, more often than not, simply chance. Those in the public eye usually gain large numbers of new subscribers for being right by random luck. Which brings us to another important probability error that falls under the broad rubric of representativeness. Amos Tversky and Daniel Kahneman call this one the “law of small numbers.”‘. The statistically valid “law of large numbers” states that large samples will usually be highly representative of the population from which they are drawn; for example, public opinion polls are fairly accurate because they draw on large and representative groups. The smaller the sample used, however (or the shorter the record), the more likely the findings are chance rather than meaningful. Yet the Tversky and Kahneman study showed that typical psychological or educational experimenters gamble their research theories on samples so small that the results have a very high probability of being chance. This is the same as gambling on the single good call of an advisor. The psychologists and educators are far too  confident in the significance of results based on a few observations or a short period of time, even though they are trained in statistical techniques and are aware of the dangers.

Note how readily people over generalize the meaning of a small number of supporting facts. Limited statistical evidence seems to satisfy our intuition no matter how inadequate the depiction of reality. Sometimes the evidence we accept runs to the absurd. A good example of the major overemphasis on small numbers is the almost blind faith investors place in governmental economic releases on employment, industrial production, the consumer price index, the money supply, the leading economic indicators, etc. These statistics frequently trigger major stock- and bond-market reactions, particularly if the news is bad. Flash statistics, more times than not, are near worthless. Initial economic and Fed figures are revised significantly for weeks or months after their release, as new and “better” information flows in. Thus, an increase in the money supply can turn into a decrease, or a large drop in the leading indicators can change to a moderate increase. These revisions occur with such regularity you would think that investors, particularly pros, would treat them with the skepticism they deserve. Alas, the real world refuses to follow the textbooks. Experience notwithstanding, investors treat as gospel all authoritative-sounding releases that they think pinpoint the development of important trends. An example of how instant news threw investors into a tailspin occurred in July of 1996. Preliminary statistics indicated the economy was beginning to gain steam.

The flash figures showed that GDP (gross domestic product) would rise at a 3% rate in the next several quarters, a rate higher than expected. Many people, convinced by these statistics that rising interest rates were imminent, bailed out of the stock market that month. To the end of that year, the GDP growth figures had been revised down significantly (unofficially, a minimum of a dozen times, and officially at least twice). The market rocketed ahead to new highs to August 1997, but a lot of investors had retreated to the sidelines on the preliminary bad news. The advice of a world champion chess player when asked how to avoid making a bad move. His answer: “Sit on your hands”. But professional investors don’t sit on their hands; they dance on tiptoe, ready to flit after the least particle of information as if it were a strongly documented trend. The law of small numbers, in such cases, results in decisions sometimes bordering on the inane. Tversky and Kahneman’s findings, which have been repeatedly confirmed, are particularly important to our understanding of some stock market errors and lead to another rule that investors should follow.

1. Which statement does not reflect the true essence of the passage

1. Tversky and Kahneman understood that small representative groups bias the research theories to generalize results that can be categorized as meaningful result and people simplify the real impact of passable portray of reality by small number of supporting facts.
2. Governmental economic releases on macroeconomic indicators fetch blind faith from investors who appropriately discount these announcements which are ideally reflected in the stock and bond market prices.
3. III. Investors take into consideration myopic gain and make it meaningful investment choice and fail to see it as a chance of occurrence.
4. Irrational overreaction to key regulators expressions is same as intuitive statistician stumbling disastrously when unable to sustain spectacular performance.

(a)   Only I

(b)   Only IV

(c)   II & III

(d)   Only III

Ans: ()

2. The author of the passage suggests the anomaly that leads to systematic errors in predicting future. Which of the following statement does not best describe the anomaly as suggested in the passage above.

1. The psychological pressures account for the anomalies just like soothsayers warning about the doomsday and natural disasters and market crashes.
2. Contrary to several economic and financial theories investors are not good intuitive statistician, especially under difficult conditions and are unable to calculate the odds properly when making investments choices.
3. III. Investors are swamped with information and they react to this avalanche of data by adopting shortcuts or rules of thumb rather than formally calculating odds of a given outcome.
4. The distortions produced by subjectively calculated probabilities are large, systematic and difficult to eliminate even when investors are fully aware of them.

(a)   Only I

(b)   Only IV

(c)   I & III

(d)   II & IV

Ans: ()

3. “Tversky and Kahneman’s findings… lead to another rule that investors should follow”. Which rule is the author talking about?

1. Not to be influenced by short term and occasional record of a money manager, broker, analysts, or advisor, no matter how impressive.
2. To accept cursory economic or investment news without significant substantiation but supported by statistical evidence even if limited in data sufficiency.
3. III. In making decisions we become overly immersed in the details of a particular situation and consider all the outcomes of similar experience in our past.
4. None of the above.

(a)   Only IV

(b)   Only I

(c)   Only III

(d)   I, II, & III

Ans: ()

4. According to the passage which statement written below is farthest in explaining the meaning of the passage above?

1. Market letter writers have been wrong in their judgments many a times but they continue to express their opinion as dramatic predictions and well time call results in huge rewards to analysts, journalist and popular writers.
2. II, Public opinion polls are fairly accurate because they are based on randomly selected diminutive representative groups and hence are more meaningful than intuitive statistics of an outcome.
3. III. People generally limit the need for hefty statistical evidence as it satisfies their intuition without reflecting the reality.
4. None of the above.

(a)   Only IV

(b)   Only II

(c)   II & III

(d)   Only I

Ans: ()

(Source: IIFT-2010)

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