Saving Investors From Themselves

June 28, 2013

Jason Zweig has written one of the best personal finance columns for years, The Intelligent Investor for the Wall Street Journal.  Today he topped it with a piece that describes his vision of personal finance writing.  He describes his job as saving investors from themselves.  It is a must read, but I’ll give you a couple of excerpts here.

I was once asked, at a journalism conference, how I defined my job. I said: My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.

That’s because good advice rarely changes, while markets change constantly. The temptation to pander is almost irresistible. And while people need good advice, what they want is advice that sounds good.

The advice that sounds the best in the short run is always the most dangerous in the long run. Everyone wants the secret, the key, the roadmap to the primrose path that leads to El Dorado: the magical low-risk, high-return investment that can double your money in no time. Everyone wants to chase the returns of whatever has been hottest and to shun whatever has gone cold. Most financial journalism, like most of Wall Street itself, is dedicated to a basic principle of marketing: When the ducks quack, feed ‘em.

In practice, for most of the media, that requires telling people to buy Internet stocks in 1999 and early 2000; explaining, in 2005 and 2006, how to “flip” houses; in 2008 and 2009, it meant telling people to dump their stocks and even to buy “leveraged inverse” exchange-traded funds that made explosively risky bets against stocks; and ever since 2008, it has meant touting bonds and the “safety trade” like high-dividend-paying stocks and so-called minimum-volatility stocks.

It’s no wonder that, as brilliant research by the psychologist Paul Andreassen showed many years ago, people who receive frequent news updates on their investments earn lower returns than those who get no news. It’s also no wonder that the media has ignored those findings. Not many people care to admit that they spend their careers being part of the problem instead of trying to be part of the solution.

My job, as I see it, is to learn from other people’s mistakes and from my own. Above all, it means trying to save people from themselves. As the founder of security analysis, Benjamin Graham, wrote in The Intelligent Investor in 1949: “The investor’s chief problem – and even his worst enemy – is likely to be himself.”

……..

From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.

But humans perceive reality in short bursts and streaks, making a long-term perspective almost impossible to sustain – and making most people prone to believing that every blip is the beginning of a durable opportunity.

……..

But this time is never different. History always rhymes. Human nature never changes. You should always become more skeptical of any investment that has recently soared in price, and you should always become more enthusiastic about any asset that has recently fallen in price. That’s what it means to be an investor.

Simply brilliant.  Unless you write a lot, it seems deceptively easy to write this well and clearly.  It is not.  More important, his message that many investment problems are actually investor behavior problems is very true—and has been true forever.

To me, one of the chief advantages of technical analysis is that it recognizes that human nature never changes and that, as a result, behavior patterns recur again and again.  Investors predictably panic when market indicators get deeply oversold, just when they should consider buying.  Investors predictably want to pile into a stock that has been a huge long-term winner when it breaks a long-term uptrend line—because “it’s a bargain”—just when they might want to think about selling.  Responding deliberately at these junctures doesn’t usually require the harrowing activity level that CNBC commentators seem to believe is necessary, but can be quite effective nonetheless.  Technical indicators and sentiment surveys often show these turning points very clearly, but as Mr. Zweig describes elsewhere in the article, the financial universe is arranged to deceive us—or at least to tempt us to deceive ourselves.

Investing is one of the many fields where less really is more.

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Sector and Capitalization Performance

June 28, 2013

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 6/27/2013.

s_c 06.28.13

Numbers shown are price returns only and are not inclusive of transaction costs.  Source: iShares

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Recession Watch 2013

June 28, 2013

Every time the market corrects, pundits start looking for a recession.  It’s not a crazy idea, since the S&P 500 is a leading indicator of the economy.  Recessions are typically led by market corrections, but market corrections have also forecast ten of the last two recessions.  The stock market alone is not a reliable indicator.

Those voting against the recession idea often cite the steep yield curve as a sign the economy is strong.  (See, for example, here and here.)  Recessions typically are preceded by an inverted yield curve, where short-term yields are higher than long-term yields, and we are far from that right now.

Those voting in favor of the recession point out a variety of weakening data series that often forecast recessions, especially new order indexes, credit spreads, and oil prices.  (See, for example, here, here, here, and here.)  Earnings and revenues are decelerating and that causes economists to fear for the future.  Many indicators of this type are not actually negative yet, but the fear is that they will become so.

The truth is that no one knows what will happen.

You are right to be skeptical of economic forecasts.  Most economists did not see the 2008 housing bust and recession coming—and on the other side of the coin, a few economists are still stubbornly clinging to their 2011 recession calls.  The market corrected sharply, the economy slowed, but a recession was ultimately avoided as the economy picked back up.

Part of the rationale for the way we do tactical asset allocation is that we do not have to forecast—we change when the relative strength of asset classes or sectors changes.  The biggest problem with forecasting is that people tend to have an opinion, which they proceed to back up by only looking at confirming evidence.  Both bulls and bears can always point to signs of improvement or signs of deterioration.  Trend following avoids that whole problem and just goes with the flow.  As market expectations change, holdings in a relative strength portfolio change right along with them.  Trend following is never ideal, but it’s mostly in the ballpark most of the time—and it’s way less stressful than worrying about the economy constantly.

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“Doing God’s Work”

June 27, 2013

Nice fake Lloyd Blankfein quote—from an article on The Onion.

“It’s been about five or six years since we last crippled every major market on the planet, so it seems like the time is right for us to get back out there and start ruining the lives of billions of people again,” said Goldman Sachs CEO Lloyd Blankfein. “We gave it some time and let everyone get a little comfortable, and now we’re looking to get back on the old horse, shatter some consumer confidence, and flat-out kill any optimism for a stable global economy for years to come.”

“People are beginning to feel at ease spending money and investing in their futures again,” Blankfein continued. “That’s the perfect time to step in and do what we do best: rip the heart right out of the world’s economy.”

I’m beginning to think about using The Onion as a market timing tool!  They cranked this satirical article out right as the markets took a tumble and everyone was feeling nervous.  Funny, but maybe a little too close to home!

 

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Fund Flows

June 27, 2013

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 06.27.13

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Cage Match: Pension vs. 401k

June 26, 2013

Chuck Jaffe recently had a good retirement article on Marketwatch.  He covered a number of topics, especially longevity estimates, but he also had the most succinct explanation of the difference between how a pension and a 401k plan works.  Here it is:

In the days when corporate pensions were the primary supplement to Social Security, Americans were able to generate a lifetime income, effectively, by putting everyone’s lifetime in a pool, then saving and managing the pooled assets to meet the target.

The individuals in a pension plan would live out their lives, but the actuaries and money managers would adjust the pool based on the life experience of the group. Thus, if the group had a life expectancy of living to age 75 – which statistically would mean that half of the pensioners would die before that age, and half would die afterwards – longevity risk was balanced out by the group experience.

Now that we have shifted to making individuals responsible for generating their lifetime income stream, there is no pool that shares the risk of outliving assets.

The bold is mine, but the distinction should be pretty clear.  With a pension plan, you’re covered if you live a long time—because your extra payouts are covered by the early mortality of some of the other participants.  It’s a shared-risk pool.

In a 401k, there’s only one participant.  You.  In other words, you’re on your own.

With a 401k, the only way to cover yourself adequately is to assume you are going to live a long time and save a lot to reserve for it.  If you’ve got enough assets to cover yourself to age 100, the most negative outcome is that your heirs will think very fondly of you.  If you are covered for only a few years of retirement, you’ll need to either keep working, eat Alpo, move in with your kids, or possibly take up motorcycle racing and sky-diving.  None of those sound like great options to me.

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Small Caps Leading the Way in 2013

June 26, 2013

One of the tools on the Dorsey Wright research database that I check regularly is called the Asset Class Matrix which takes a broad universe of asset classes and ranks them by their relative strength.  Current ranks are shown below.  For this particular matrix, the Vanguard Small-Cap ETF (VB) is used as a proxy for U.S. small-cap stocks.  You will notice that small caps are currently ranked near the top, reflecting their superior relative strength.

asset class matrix 06.26.13

Source: Dorsey Wright, 6/25/2013 (Click to enlarge)

However, a cap-weighted small cap ETF like VB is not the only option in the small-cap space.  I referred to Stock-Encyclopedia.com to get a broader list of available small-cap ETFs.  In the table below, you will find growth, value, equal-weighted, fundamentally-weighted, and last but certainly not least, relative strength or momentum-weighted small-cap ETFs.  So far this year, small caps have put up some impressive numbers, but the best performer of them all is our PowerShares DWA Small Cap Technical Leaders ETF (DWAS). 

dwas 06.26.13

Source: Dorsey Wright, Updated through 6/25/2013 (Click to enlarge)

A description of the index methodology for this small-cap momentum ETF (DWAS) is as follows:

The PowerShares DWA SmallCap Technical Leaders™ Portfolio (the “Fund”) seeks investment results that generally correspond (before fees and expenses) to the price and yield of the Dorsey Wright SmallCap Technical Leaders™ Index (the “Underlying Index”). The Fund generally will invest at least 90% of its total assets in equity securities of small capitalization companies that comprise the Underlying Index. The Index includes securities pursuant to a Dorsey Wright & Associates (“Dorsey Wright” or the “Index Provider”) proprietary selection methodology that is designed to identify companies that demonstrate powerful relative strength characteristics. The Index Provider determines a company’s relative strength characteristics based on that company’s market performance. The Index Provider selects approximately 200 companies for inclusion in the Underlying Index from a small-cap universe of approximately 2,000 of the smallest U.S. companies selected from a broader set of 3,000 companies. The Fund and the Index are rebalanced and reconstituted quarterly.

The Dorsey Wright SmallCap Technical Leaders Index is calculated by Dow Jones, the marketing name and a licensed trademark of CME Group Index Services LLC (“CME Indexes”). “Dow Jones Indexes” is a service mark of Dow Jones Trademark Holdings LLC (“Dow Jones”).  Products based on the Dorsey Wright SmallCap Technical Leaders IndexSM, are not sponsored, endorsed, sold or promoted by CME Indexes, Dow Jones and their respective affiliates make no representation regarding the advisability of investing in such product(s).  

Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.    You should consider this strategy’s investment objectives, risks, charges and expenses before investing.  The examples and information presented do not take into consideration commissions, tax implications, dividends, or other transaction costs. 

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High RS Diffusion Index

June 26, 2013

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 6/25/13.

diffusion 06.26.13

The 10-day moving average of this indicator is 62% and the one-day reading is 45%.  Dips in this indicator have often provided good opportunities to add money to relative strength strategies.

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No Margin For Error

June 25, 2013

Economicpic points out that drawdown in the Barclays Aggregate Bond Index is only about 4%, but that is 1.6 years worth of yield—the largest income drawdown ever.

bond

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Large Spike in ‘Smart Beta’ Investments

June 25, 2013

The Financial Times reports that there has been a “large spike in ‘smart beta’ investments:”

Interest in “advanced” or “smart beta” investment strategies is accelerating, with growing numbers of investors adopting alternative weighting schemes in equity and fixed income portfolios.

Inflows into advanced beta funds reached $15bn in the first three months of 2013, up 45.3 per cent on the same period a year ago. This was the strongest quarterly inflow for three years, according to an analysis by State Street Global Advisors of Morningstar data.

Total inflows into advanced beta funds over the past three years was $81.6bn. Most of the growth is being generated via exchange traded funds, which have attracted inflows of $66.2bn over the past three years.

inflows 06.25.13

Our four momentum ETFs have seen similar growth patterns.  As reported by Invesco, these ETFs have had inflows of $501 million so far this year:

powershares inflows

As of 6/24/13 (click to enlarge)

Strong demand for smart beta strategies is now being seen across all levels of the industry, including institutional investors:

“Index-based investing is becoming much more sophisticated,” said Scott Stark, director of Russell Indexes Europe. He says discussions with institutional investors and pension funds over the past year have been dominated by questions about advanced beta.

“The depth of conversations with clients about advanced beta has shifted dramatically. More and more are asking how best to incorporate advanced beta strategies into their portfolios,” added Mr Stark.

The Dorsey Wright SmallCap Technical Leaders Index is calculated by Dow Jones, the marketing name and a licensed trademark of CME Group Index Services LLC (“CME Indexes”). “Dow Jones Indexes” is a service mark of Dow Jones Trademark Holdings LLC (“Dow Jones”).  Products based on the Dorsey Wright SmallCap Technical Leaders IndexSM, are not sponsored, endorsed, sold or promoted by CME Indexes, Dow Jones and their respective affiliates make no representation regarding the advisability of investing in such product(s).  Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.    You should consider this strategy’s investment objectives, risks, charges and expenses before investing.  The examples and information presented do not take into consideration commissions, tax implications, dividends, or other transaction costs. See www.powershares.com for more information.

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Relative Strength Spread

June 25, 2013

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks).  When the chart is rising, relative strength leaders are performing better than relative strength laggards.    As of 6/24/2013:

spread 06.25.13

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Weekly RS Recap

June 24, 2013

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength quartile and then compared to the universe return.  Those at the top of the ranks are those stocks which have the best intermediate-term relative strength.  Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (6/17/13 – 6/21/13) is as follows:

ranks 06.24.13

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Client Sentiment Survey – 6/21/13

June 21, 2013

Here we have the next round of the Dorsey, Wright Sentiment Survey, the first third-party sentiment poll.  Participate to learn more about our Dorsey, Wright Polo Shirt raffle! Just follow the instructions after taking the poll, and we’ll enter you in the contest.  Thanks to all our participants from last round.

As you know, when individuals self-report, they are always taller and more beautiful than when outside observers report their perceptions!  Instead of asking individual investors to self-report whether they are bullish or bearish, we’d like financial advisors to weigh in and report on the actual behavior of clients.  It’s two simple questions and will take no more than 20 seconds of your time. We’ll construct indicators from the data and report the results regularly on our blog–but we need your help to get a large statistical sample!

Click here to take Dorsey, Wright’s Client Sentiment Survey.

Contribute to the greater good!  It’s painless, we promise.

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Sector and Capitalization Performance

June 21, 2013

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 6/20/2013.

s_c 06.21.13

Numbers shown are price returns only and are not inclusive of transaction costs.  Source: iShares

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(Really) Long-Term Perspective on Interest Rates

June 20, 2013

With interest rates surging in recent days, I think it is interesting to stand back and look at a chart of the 10-Year Treasury Yield from a broader historical perspective.  Via Business Insider:

image001-23

Source: Global Financial Data (click to enlarge)

Business Insider’s take:

So if you believe in the power of mean reversion, then it’s not unreasonable to expect yields to head back up toward 4%.

Although investors have grown accustomed to interest rates primarily moving in one direction (down) over the past 30+ years, history shows a number of periods of extended rising rate environments.  Needless to say, it is quite possible that there will be opportunities to add value over a passive approach to fixed income exposure by being tactical in years ahead.  In the context of multi-asset class portfolios, that may mean underweighting fixed income altogether.  For allocations within fixed income, it may mean being more discriminating when determining what sectors of fixed income to own.  I suspect that relative strength may prove to be very valuable in the years ahead as it relates to fixed income exposure.

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Fund Flows

June 20, 2013

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 06.20.13

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High RS Diffusion Index

June 19, 2013

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 6/18/13.

diffusion 06.19.13

The 10-day moving average of this indicator is 72% and the one-day reading is 82%.

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Relative Strength Spread

June 18, 2013

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks).  When the chart is rising, relative strength leaders are performing better than relative strength laggards.    As of 6/17/2013:

RS Spread 06.18.13

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Endowment-Style Investing

June 17, 2013

Institutional Investor interviews Eric Upin to discuss global-endowment style investing.

How do institutions approach global multiasset-class investing?

It’s all about asset allocation, manager selection and risk management.  Global multiasset-class investing is a team sport, whether you’re an endowment, sovereign wealth fund or foundation.  When you’re investing around the world, trying to bring professionals together to make judgments such as whether you should be overweight or underweight Europe, real estate or other asset classes, the more smart people you can bring into the tent who do what you do — and who can help provide opinions and spark ideas — the better.

As a quantitative manager, this description of how to ultimately determine an asset allocation is completely foreign.  Maybe it works great for some, but the idea of trying to get an edge on the market by seeking out “smart people” who can help provide opinions and spark ideas seems problematic.  We have no aversion to smart people, however we do have a strong preference for removing the role of judgement calls in the investment process.  For us, the asset allocation decision goes something like this.  We determine an investment universe that is comprised of a broad range of asset classes.  We determine the model constraints (i.e. how much we can overweight or underweight a given asset class), and then apply our relative strength methodology to ranking the different asset classes and each of the individual components of the investment universe.  Then, our weights to different asset classes and exact holdings are determined by a systematic relative strength model.  Likewise, sell decisions are also based on this relative strength ranking process.

Those interested in seeing just how effective this quantitative approach to asset allocation can be over time, can read Tactical Asset Allocation Using Relative Strength by John Lewis.  This approach is also working well this year, as discussed in DWTFX Tops Peers.

Past performance is no guarantee of future results.  Please click here and here for disclosures.

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Weekly RS Recap

June 17, 2013

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile and then compared to the universe return.  Those at the top of the ranks are those stocks which have the best intermediate-term relative strength.  Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (6/10/13 – 6/14/13) is as follows:

ranks 06.17.13

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DWTFX Tops Peers

June 14, 2013

Earlier this year, we featured an excellent resource published by our partners at Arrow Funds called Relative Strength Turns. You can access a PDF of the brochure by clicking here. This research discusses the type of behavior you can expect from a relative strength driven strategy in various market cycles and it makes the case for why relative strength strategies may experience favorable returns in the years ahead.

Interestingly, we have seen this corroborated by the performance of the Arrow DWA Tactical Fund, which employs a largely unconstrained application of relative strength to multiple asset classes. With YTD performance of 10.65% through 6/13/13, it is outperforming 99% of its peers in the Morningstar World Allocation category.

DWTFX

Past performance is no guarantee of future returns.

This strategy is available in the Arrow DWA Tactical Fund (DWTFX) and also as a separately managed account as our Global Macro strategy, which is available on a number of major platforms, including the Wells Fargo Masters and DMA platforms.

Please click here and here for disclosures.

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Sector and Capitalization Performance

June 14, 2013

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 6/13/2013.

s_c 06.14.13

Numbers shown are price returns only and are not inclusive of transaction costs.  Source: iShares

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The Stock Market – Economy Disconnect

June 13, 2013

One of the most difficult things for investors to understand is the stock market – economy disconnect.  New investors almost always assume that if the economy is doing well, the stock market will perform well also.  In fact, it is usually the other way around!

Liz Ann Sonders, the market strategist at Charles Schwab & Co., has an interesting piece on this apparent disconnect.  She writes:

Remember, the stock market (as measured by the S&P 500) is one of 10 sub-indexes in the Conference Board’s Index of Leading Indicators. Many investors assume it’s the opposite—that economic growth is a leading indicator of the stock market. For a compelling visual of the relationship, see the following pair of charts, which I’ll explain below.

The most compelling part of her article follow, in the form of her charts that show the GDP growth rate and peaks and troughs in the stock market.

Source: Charles Schwab & Co.  (click on images to enlarge)

More often than not, poor economic growth corresponds with a trough in the market.  Super-heated economic growth is usually a sign that someone is about to take away the punch bowl.

In truth, there is really no disconnect if you accept that the stock market usually leads the economy.  As Ms. Sonders points out, the S&P 500 is part of the Index of Leading Indicators.  A lot of investors have trouble wrapping their heads around that concept—and it continues to cost them money.

The contrast to economic forecasting (i.e., guessing) is trend following.  The trend follower is usually fairly safe in believing that if the market is continuing up that is economy is probably ok for the time being.  When the trend becomes uncertain or tilts down, it might be time to look for clues that the economy is softening.  You’re not going to be right all the time either way, but at least you’ve got the odds on your side if you let the market lead.

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Fund Flows

June 13, 2013

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 06.13.13

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Competency Transference

June 12, 2013

From Barry Ritholz at The Big Picture comes a great article about what he calls “competency transference.”  His article was triggered by a Bloomberg story about a technology mogul who turned his $1.8 billion payoff into a bankruptcy just a few years later.  Mr. Ritholz points out that the problem is generalizable:

Be aware of what I call The Fallacy of Competency Transference. This occurs when someone successful in one field jumps in to another and fails miserably. The most widely known example is Michael Jordan, the greatest basketball player the game has ever known, deciding he was also a baseball player. He was a .200 minor league hitter.

I have had repeated conversations with Medical Doctors about this: They are extremely intelligent accomplished people who often assume they can do well in markets. (After all, they conquered what I consider a much more challenging field of medicine).

The problem they run into is that competency transference. After 4 years of college (mostly focused on pre-med courses), they spend 4 years in Medical school; another year as an Interns, then as many as 8 years in Residency. Specialized fields may require training beyond residency, tacking on another 1-3 years. This process is at least 12, and as many as 20 years (if we include Board certification).

What I try to explain to these highly educated, highly intelligent people is that they absolutely can achieve the same success in markets that they have as medical professionals — they just have to put the requisite time in, immersing themselves in finance (like they did in medicine) for a decade or so. It is usually around this moment that the light bulb goes off, and the cause of prior mediocre performance becomes understood.

To me, the funny thing is that competency transference mostly applies to the special case of financial markets.  For example, no successful stock market professional would ever, ever assume themselves to be a competent thoracic surgeon without the requisite training.  Nor would a medical doctor ever assume that he or she could play a professional sport  or run a nuclear submarine without the necessary skills.  (I think the Michael Jordan analogy is a poor one, since there have been numerous multi-sport athletes.  Many athletes letter in multiple sports in high school and some even play more than one in college.    Michael Jordan may have been wrong about his particular case, but it wasn’t necessarily a crazy idea.)

Nope, competency transference is mostly restricted to the idea that anyone watching CNBC can become a market maven.  (Apparently even talking heads on CNBC believe this.)  This creates no end of grief in advisor-client relationships if 1) the advisor isn’t very far up the learning curve, and 2) if the client thinks they know better.  You would have the same problem if you had a green medical doctor and you thought you knew more than the doctor did.  That is a situation that is ripe for problems!

Advisors need to work continuously to expand their skills and knowledge if they are to be of use to investors.  And investors, in general, would do well to spend their efforts vetting advisors carefully rather than assuming financial markets are a piece of cake.

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