Are You an Expert?

Michael J. Mauboussin Legg Mason Capital Management outlines in a recent whitepaper the "Characteristics of Experts":

"Given that experts exist in diverse domains, psychologists wondered whether they have much in common. The answer: a resounding yes. Research on expert performance reveals seven robust and universal characteristics:

1. Experts excel in their own domains, but not outside their domain. Expertise is domain specific.
2. Experts perceive patterns in their domain.
3. Experts solve problems much faster than novices. Lightning chess, where players only have a few seconds to decide a move, illustrates this point well.
4. Experts have superior short and long-term memory. When tested, experts appear to have recall capacity that exceeds the limits of short-term memory.
5. Experts represent problems at a deeper level than novices...experts sort by principle-based categories, while novices sort more literally, reflecting the problem's surface features.
6. Experts spend a lot of time solving problems qualitatively.
7. Experts have a strong sense of their own fallibility. Experts tend to be more aware of their errors, why they fail, and when they need to check their answers.

I have been fond of Mauboussin's logic for years. He nails it head on most all of the time. How many people really ponder his views on "expertise" in terms of their trading? I say not many. For example, I came across a "risk capacity" survey online from a financial planning firm. Here is one of the questions with the answer choices:

How would you rate your knowledge about investing in general and more specifically, the relationship between risk, return, and time?
A. significantly below average
B. below average
C. average
D. above average
E. expert

The right answer is not the point here. If the great traders, the experts, are living Mauboussin's seven points, how does it help to pose the question above? Isn't the question above just an over-simplification to make people feel good? Doesn't it let them avoid the heavy lifting needed for real trading excellence? The firm that poses the above question also makes these assertions on their website:

1. It is virtually impossible to beat a market over time through active investing.
2. Indexing is backed by Nobel laureates who have provided unbiased, rigorous, empirical research, most notably the Modern Portfolio Theory.
3. Stock pickers are analogous to gamblers who rely on feelings and emotions when making bets.
4. Time pickers or market timers move money in and out of different investments in an attempt to profit from short-term cyclical events, which is a futile endeavor.
5. Manager picking is not a reliable practice because the past performance of money managers does not predict their future performance. Star money managers fall from their stature sooner or later, since their stellar performance is attributed to Lady Luck rather than skill.

Whoever wrote the above 5 points has not read Market Wizards, Fortune's Formula or Trend Following. Whoever wrote those 5 points doesn't believe "expertise" is possible. But it is possible. There are many trading experts or Market Wizards who have been whipping the market for decades. Consider one of the great trend followers, David Harding of Winton Capital, who was recently asked: 'Because recent performance has been good, does that necessarily mean that future performance will be bad?' His answer:

"Au contraire. There is a danger of people over extrapolating recent good performance into the future and being too optimistic about what we're going to achieve. But, equally, there is no evidence of mean reversion, in the sense that whenever we have a good period that's inevitably followed by a bad period or that when we have a bad period that's followed by a good period. It's a biased coin tossing exercise. It's like tossing coins. Luckily we strongly believe our coin will land profit side up, rather than loss side up, 60 per cent of the time. But there is no forecasting the future of our returns from our recent performance. However much your feelings tell you something, your gut tells you something, the gut is very misleading in this context."

David has that "expertise" Mauboussin speaks to. In my conversation with David he stressed that he can always tell a client how much risk he is taking, but he can never tell you how much he will make. He is clearly focused on his own fallibility? Are you focused on your own fallibility?

Holy Grail Reminder: News is Not Useful

Consider from this week:

"NEW YORK (Reuters) - U.S. stocks extended gains on Tuesday, with both the Nasdaq Composite and the S&P 500 index rising above 1 percent, as minutes from a December U.S. Federal Reserve policymakers' meeting signaled the central bank's 1-1/2 year campaign of rate increases was likely near an end. The Dow Jones industrial average jumped 80.85 points, or 0.75 percent, at 10,798.35. The Standard & Poor's 500 Index was up 14.11 points, or 1.13 percent, at 1,262.40. The technology-laced Nasdaq Composite Index advanced 29.06 points, or 1.32 percent, at 2,234.38."

Is this the trigger to enter? Is that the point of this news tidbit? Get in now? If you do get in now, when do you exit? If you do get in now, which market? If you get in now, how much do you bet of your limited bankroll?

Michael W. Covel is the founder and President of Trend Following. A researcher of the most successful Trend Following investment managers, he has been in the alternative investments industry consulting on Trend Following to individual traders, hedge funds and banks for ten years. His best selling book, Trend Following: How Great Traders Make Millions in Up or Down Markets, New Expanded Edition (Prentice Hall, November 2005) is a complete and concise guide to trend following. It includes interviews with great trend followers who have won millions if not billions in the market. The trading world has embraced the book with endorsements from Van K. Tharp, John Mauldin, Ed Seykota and many more. Trend Following is now in its fifth printing, and is currently available in a Japanese translation with Chinese, German, French, Korean and Russian translations soon to follow. Teaching and sharing unique insights about Trend Following trading and alternative investments has earned Mr. Covel respect as a rational and logical voice in uncertain times. Mr. Covel also writes for numerous industry publications including Your Trading Edge, Stocks, Futures and Options Magazine and International Petroleum Finance and is consistently quoted and interviewed by a variety of financial publications.

Mr. Covel is also Managing Editor at TurtleTrader.com, the leading Trend Following news and commentary resource since 1996. Thousands of visitors from more than 70 countries as well as hundreds of trading professionals engaged in years of debate and interchange making the site the rich archive of trading information, data and opinion that it continues to be today. TurtleTrader, one of the largest & strongest trading community on the web with over 7.5 million unique visitors since its inception, also functions as a resource center for the Trend Following Educational Course.