Stock Markets - 5

Now it simply must be true that the third statement is least likely, since any conjunction has to be less probable than either of its parts considered separately. Everybody can understand this when the principle is explained explicitly and patiently. But all groups of subjects, sophisticated students who ought to understand logic and probability as well as folks off the street corner, rank the last statement as more probable than the second. (I am particularly fond of this example because I know that the third statement is least probable, yet a little homunculus in my head continues to jump up and down, shouting at me—"but she can't just be a bank teller; read the description.")

The example with Linda as well as this paragraph and the next in response come from an article by Stephen Jay Gould on Joe Dimaggio's 56 game hitting streak.
Gould in New York Review of Books

Why do we so consistently make this simple logical error? Tversky and Kahneman argue, correctly I think, that our minds are not built (for whatever reason) to work by the rules of probability, though these rules clearly govern our universe. We do something else that usually serves us well, but fails in crucial instances: we "match to type." We abstract what we consider the "essence" of an entity, and then arrange our judgments by their degree of similarity to this assumed type. Since we are given a "type" for Linda that implies feminism, but definitely not a bank job, we rank any statement matching the type as more probable than another that only contains material contrary to the type. This propensity may help us to understand an entire range of human preferences, from Plato's theory of form to modern stereotyping of race or gender.

To sum up here, most economists believe in efficient markets and that there is no way to "beat the market." Occasionally an investor will have a stock that significantly out performs the market for a period and certainly that same investor will have some turkeys (poor performers), but on average doing as well as the market is the best an investor can hope for. One implication of this view is that if you have a balanced portfolio then sitting on it and not trading does as well as constantly trading. There are some economists who do occasionally believe the market gets out of wack, either over heated or under valued, and anyone who argues that way almost surely cites the work of Tversky and Kahneman about why people are not fully rational animals but rather make systematic errors with probabilities.

Let's turn to an issue that has already come up. We talk about stock indices and how the market as a whole performs. What are stock indices? How is the index calculated? Can you name some of these? Why is there interest in stock indices? How does the return on an individual stock compare to the return on a stock index?