Experts and Markets

Overall, the evidence suggests there is little benefit to expertise . . . Surprisingly, I could find no studies that showed an important advantage for expertise. - J. Scott Armstrong, The Seer-Sucker Theory: The Value of Experts in Forecasting Given that the stock market is a probabilistic, high-degree-of-freedom domain and the poor aggregate performance of active investment managers, there seems little reason to look for investing experts. However, a handful of distinguished investors have established excellent long-term records, which holds hope for expertise in investing.

Economist Burt Malkiel says it this way: While it is abundantly clear that the pros do not consistently beat the averages, I must admit that there are exceptions to the rule of the efficient market. Well, a few. While the preponderance of statistical evidence supports the view that market efficiency is high, some gremlins are lurking about that harry the efficient-market theory and make it impossible for anyone to state that the theory is conclusively demonstrated.

Since we don’t yet understand all the issues around expertise and have yet to study successful investors in great detail, our conclusion that there are expert investors is tentative. However, it does not appear expert-investor skill sets are transferable. Here are some of the characteristics expert investors share:

• Successful investors put in plenty of deliberate practice. In investing, this generally means lots of time reading, often across diverse fields. For example, the highly-regarded head of GEICO’s

investments, Lou Simpson, says, “I’d say I try to read at least five to eight hours per day. I read a lot of different things . . .” Berkshire Hathaway’s Charlie Munger makes the point more emphatically, “In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time—none, zero. You'd be amazed at how much Warren reads—at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out."

• Great investors conceptualize problems differently than other investors. As a group, these experts go beyond the near-term obvious issues, can identify relevant principles because of their experience, and see meaningful trends. These investors don’t succeed by accessing better information; they succeed by using the information differently than others. As an illustration, star investor and Sears Holdings chairman Eddie Lampert carefully studied Warren Buffett’s past investments to understand the logic. By reading annual reports in years preceding Buffett deals, Lampert sought to reverse engineer Buffett’s thought process. In a Business Week article, Lampert noted, "Putting myself in his shoes at that time, could I understand why he made the investments? That was part of my learning process."

• Long-term investment success requires mental flexibility.

Just as markets constantly evolve, so too must investors. Further, expert investors possess the second type of flexibility—an ability to

recognize when their easily-accessible mental models no longer apply. This recognition requires a return to basic principles to think carefully about a topic. Bill Miller’s investment-process evolution is a good case:

The [conventional value investing] approach that had been so successful for us . . . had serious shortcomings when the economy peaked and began to head down. I decided to see if the academic literature offered any insights into how we might improve our investment process. After reviewing the data . . . it became clear that the conventional wisdom about value investing was wrong. Our experience in the late 1980’s and the changes we implemented in our process allowed us to sidestep that [performance] pothole in the late 1990s.

• Not pattern recognition but process recognition. As scientist Norman Johnson notes, in complex systems an expert can create a mental simulation, fueled by diverse information. An idea or

problem solution emerges from the simulation, leaving the expert unable to explain how he or she arrived at the solution. 23 A colleague’s description of legendary hedge fund manager George

Soros makes this point:

[Gary] Gladstein, who has worked closely with Soros for fifteen years, describes hisboss as operating in almost mystical terms, tying Soros's expertise to his ability tovisualize the entire world's money and credit flows. “He has the macro vision of the entire world. He consumes all this information, digests it all, and from there he can come out with his opinion as to how this is going to be sorted out. He'll look at charts, but most of the information he's processing is verbal, not statistical.”

The research on expertise is ambiguous on how much of expertise we can attribute to innate characteristics versus deliberate practice. For example, Ericsson and Smith report, “the research approach of accounting for outstanding and superior performance in terms of general inherited characteristics has largely been unsuccessful in identifying strong and replicable relations.” 25 Our view, in contrast, is there is clearly a hard-wired element to investing success. That most investors with outstanding long-term records share a similar personality profile supports this view.

Summary

Some skepticism about the value of experts is clearly warranted. An expert’s ability to solve a problem appears largely dependent on the problem type. Computers tend to solve simple problems better, and cheaper, than experts, while collectives outperform experts for complex problems.

Posted by toughiee on Monday, December 19, 2005 at 8:34 PM | Permalink