Warren Buffett is lauded by many because few can match his investment performance. Indeed, the majority of professional fund managers cannot consistently beat the market by enough to cover their fees.
The global financial crisis of the last year or so tends to confirm that expertise is sadly lacking throughout the finance and investment industry.
Why are expert investors so hard to find? Over the last two decades, there has been considerable research into expertise and expert performance in a wide variety of fields, from sports to the arts, from fire fighting to surgery. It has yielded many interesting and useful insights.
For example, expertise is typically domain specific; an expert in one domain is seldom expert in another, probably because of the cognitive and time resources required to become an expert in just one domain.
As might be expected, experts typically have exceptional skill and knowledge, and experience, within their specific domains.
Not so expected, perhaps, is the fact that experts identified by their reputation or their extensive experience are not always able to exhibit reliably superior performance. In other words experience may be necessary to achieve expertise but it is not sufficient.
The performance of most people (even professionals) within a domain increases for a limited time until they reach an acceptable level, after which their performance levels off.
Most experts have undertaken a prolonged period of deliberate practice, usually guided by a teacher. Deliberate practice can extend the learning period. It can also mitigate age-related declines in performance.
Through a combination of deliberate practice and accumulated experience, experts develop an ability to organise, store and recall their knowledge in more meaningful and more useful patterns or 'chunks' than non-experts.
Such chunking of information allows experts to recognise quickly what is typical and what is atypical within their domains. In some domains, such as fire fighting and driving, recognising what is atypical may be of critical importance.
Chunking underlies early and accurate decision-making performance. It is a key contributor to expert performance.
Experts also tacitly associate their perceptions of what is happening with appropriate actions. This coupling of perceptions with actions allows experts to proceduralise their knowledge into decision rules that are refined over time through both deliberate practice and experience within their domains.
Much of the expertise research focuses on domains with structured environments, such as chess and other games, sport, music, maths, history, diagnostic medicine, driving, air traffic control, software design and writing.
An important feature of expertise within all these varied domains is experts’ cognitive ability to quickly and accurately relate the events they encounter with the domain-specific patterns of information they have stored in their long-term memories.
Perhaps the lack of expertise in investing is due to the nature of the domain.
Price movements, or returns, in financial markets have been modelled as random walks, non-stationary time series, chaos and complex adaptive systems – all of which lack structure, or apparent structure. A lack of structure would make it difficult to form, store and recall meaningful patterns of information.
Another feature of the investing domain is that investors receive a never-ending flow of 'news' about a constantly changing investment environment. They often have to make decisions based on information that is ambiguous and incomplete, making it difficult for investors to form accurate representations of what is happening or what is likely to happen in the future.
Nassim Taleb has recently popularised the notion of "black swan” events – rare and unpredictable events with important consequences – as a key determinant of investment risk and returns. Because of their rarity, it is difficult to accumulate experience of black swan events.
So, investors are often poorly informed as they operate in an environment with little apparent structure, and in which atypical events may make or break their performance. Given those domain characteristics, it seems hardly surprising that expert investors are so hard to find.
As the current financial crisis begins to wane, governments, regulators and industry leaders are focussing on regulatory and governance issues in order to prevent or diminish the chances of a reoccurrence. However, a greater need may be to develop a fuller understanding of why expert investors are so scarce and how true expertise may be developed within this challenging domain.
Graham Cocks is a Senior Fellow in the Department of Finance at The University of Melbourne and Senior Consultant – Funds Management at the Melbourne Centre for Financial Studies.