http://www.uesp.net/wiki/Lore:The_Old_Ways_%28Daggerfall%29, second paragraph, second sentence reads: "Any neophyte of Artaeum knows that the spirits are our ancestors, and that, while living, they too were bewildered by the spirits of their ancestors, and so on to the original Acharyai."

Now, when people on Nirn die, their souls go to the Dreamsleeve to be recycled. 'Tis like dropping a droplet of water into a large pond. Once that droplet (soul) falls into the pond (Dreamsleeve) it is no longer an individual droplet (individual soul associated with the particular individual) but now a part of the pond (Dreamsleeve) and if you dip your finger in that same spot, you're getting a fresh new droplet on your fingertip (new soul).

So from that, how is it that we have spirits and ancestors when all spirits get recycled in the Dreamsleeve and nobody is able to retain their individuality after they die?