Monday, March 10, 2008

Selecting Investment Experts - I

Marc Faber, a noted investor, once remarked “Investors want to believe in an "expert", in the same way the sick will often believe in a faith healer. They want a clear opinion about the future direction of the investment markets, without any recognition of the fact that, at least 50% of the time, deference to such views will lead to significant losses, as, no matter how diligent we "experts" are, we nevertheless remain largely ignorant of the future.”

When investment fiduciaries select investment managers/funds for their portfolios they must address two essential questions. Can expertise in active investment management add consistent value to their portfolio and, if so, what recognizable characteristics can be used to identify that expertise?

Scientific research addressing these questions may help fiduciaries answer these questions. Time magazine ran a recent article The Science of Experience on the value of experience and expertise related to the presidential race. The article distilled the findings of research by Anders Ericsson, a 58-year-old psychology professor at Florida State University, and fellow researchers who have studied the question of what makes people really good at a given pursuit. Their studies have been published in The Cambridge Handbook of Expertise and Expert Performance. This reference is a compendium of studies from over scientists who have studied exceptional performance using scientific methods across a wide variety of domains which included stock picking. In reviewing other references to this topic here and here,the following general conclusions are made:
“The trait commonly call talent is highly overrated”
"Consistently and overwhelmingly, the evidence showed that experts are always made, not born”
“10 years is a necessary minimum to achieve expertise in most fields though it doesn't guarantee success”
"The number of years of experience in a domain is a poor predictor of attained performance."
“practice makes perfect …the amount and quality of practice were key factors in the level of expertise people achieved”
“when it comes to choosing a life path, you should do what you love — because if you don't love it, you are unlikely to work hard enough to get very good”
When it comes to stock-picking the general results may not be that surprising. “Ericsson notes that some entire classes of experts — for instance, those who pick stocks for a living — are barely better than novices".

A specific study on this topic The Enigma of Financial Expertise: Superior and Reproducible Investment Performance in Efficient Markets identified in the NY Times Freakanomics blog was authored by Ericsson, Patic Andersson and Ed Cokely. This study provides both good news and bad new for those who want to believe in investment experts. While there is clear evidence that investment skill exists within a subset of investment managers, the aggregate costs of investing overwhelm the aggregate value of investment expertise.
“Our review demonstrates reliable and reproducible effects of consistently superior performance in investment and forecasting even for markets that are consistent with the efficient market hypothesis (Fama, 1970, 1991). With the possible exception of the advantage of trading by insiders, the advantage offered by expert investors is too small to allow profitable transactions, yet sufficiently large to show reliable gross abnormal returns, before the costs of the transaction ( recently estimated at $100B across the market) are subtracted. From the point of view of expertise research we find that there are consistent individual differences among experts, with experts exhibiting specialization, and demonstrating superior and reproducible investment and forecasting performance.
In identifying investment expertise, the study suggests that specialization in particular industries, strategies or companies are correlated to superior investment performance.
“the superiority demonstrated by expert investors and analysts can be traced to deeper and more accurate knowledge about companies, a finding consistent with evidence from other domains of expertise like accounting and medicine. In fact, virtually all experts are remarkably specialized, such as scientists working on very constrained research problems, elite musicians only playing a limited repertoire on a single instrument, and expert athletes only excelling in one type of sport.
Specialization in particular industries and in-depth (insider) knowledge about specific companies would be recognizable markers related to reproducibly superior investment performance according to this work.

We will provide additional thoughts on the markers of investment expertise in a related post.

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