On the Dangers of Conflating Experience and Expertise

Ben Carlson at A Wealth of Common Sense published an article about how many investors conflate experience and expertise in markets. This is one of the most misunderstood aspects of the investment business, and costs investors billions each year.

Carlson quotes Michael Maubisson, who defines expertise as having a model that works. This obviously resonates strongly with us, as our investment decisions are exclusively model-driven. I particularly felt Ben’s rant, near the end of the article, about how investors focus on experience as a primary measure of expertise:

My problem with this line of thinking is that I’ve seen people who have been in this industry for decades, yet continue to make the same mistakes over and over again because of career risk or an inability (or reason) to change. There are also many people and organizations who claim to be experts, but really have no idea what they’re talking about.  Most financial “experts” are really just very adept at selling themselves or their narrative to an unsuspecting audience.

I couldn’t agree more. In order to be a successful investor, you need both experience and expertise. Expertise without experience is dangerous because it results in overconfidence, and overconfidence in markets is a ticking bomb. A manager needs to bleed a few times in battle with the markets before he knows what he’s up against. Furthermore, many of the concepts taught in financial textbooks aren’t practical when faced with real-time decisions and hard dollars in uncertain markets.

That said, most investors can spot a green manager, and minimum track record lengths necessitate that managers gain a certain amount of experience before they are able to accumulate meaningful amounts of capital, so this is a more minor issue.

The more insidious problem is that many investment ‘experts’ persist in the business because they possess skills and talents that are only peripherally related to investment decision making. These people, who have experience but no real expertise, are able to thrive because they can speak the lingo, are effective salespeople, and/or are politically ambitious. In truth, I think many of these people have convinced themselves that they do possess expertise, but in reality they fail Maubisson’s basic test: they do not possess a model that works.

While experience is relatively easy for even an amateur investor to detect, it is much harder to determine whether an investor has any significant expertise. Many investors – even institutions and consultants who should know better – use historical returns as a shortcut to measure a manager’s expertise. But over traditional evaluation horizons of 3, 5 or even 10 years a manager’s actual expertise is very difficult to distinguish from luck. And in markets, luck can manifest in many unexpected ways:

A manager’s experience may coincidentally be aligned with one or more of the market’s prevailing themes. For example, a value biased investor may be evaluated over a period that has been particularly favourable to the value factor, or a resource biased investor may start his investment career during a commodity bull market. In both these cases, the market and a happy coincidence led to positive outcomes; the manager’s individual expertise had little to do with hit.

A manager might begin his career at a particularly favourable time. In my job I have occasion to meet many managers, and it is remarkable how many extremely successful brokers happened to enter the business in the very early 1980s, just before stocks ripped higher by over 15% a year for 20 years. Other younger advisors often began their career in 2008-2009; as a result they didn’t have a chance to blow-up many clients, and they benefitted from the huge surge in stocks over the past 6 years. A focus on dividend paying stocks was particularly fortuitous in this cycle, so many of the advisors who are thriving happen to have a dividend focus. Had they entered the business in the mid-1990s with a dividend focus, they would have been chased out of the business in short order, as dividend stocks under performed the broad market by 5+% per year for several years in a row.

Some managers succeed purely by making lucky investment decisions for while. Considering just the 30 stocks in the Dow, there are 155 million choices of 15 stock portfolios. If investment managers were monkeys, we would expect some people to choose outperforming portfolios and others to choose under performing portfolios purely by chance. Thoughtful asset allocators can use statistical tools to determine the probability that a manager’s performance is due to luck, but the average investor is often misled.

Given that luck plays such a large role in investment outcomes, investors should avoid focusing too narrowly on realized investment performance when judging a manager’s expertise. Instead, investors should probe deeply about a manager’s underlying process, and ask for meaningful proof that the process should work. A good process should have roots in fundamental investment theory and/or behavioural theory. In addition, a manager should be able to point to strong statistical substantiation from credible sources and his own testing. Lastly, you should ask for proof that the manager sticks to his process through thick and thin; if not, the manager’s own biases and emotions will almost surely derail investment outcomes when the chips are down.

It’s easy to understand why investors would think that experience adds up to expertise in markets. Unfortunately, evaluating a manager’s experience, or even his track record, is a weak substitute for due diligence. Nobody said investing would be easy.

Highly recommend Ben Carlson’s full article here: http://awealthofcommonsense.com/experience-or-expertise/