The Myth of Financial Expertise: Why Professional Wine Tasters and Stock Pickers are Clueless -- and How You Can Beat Them

The following is an excerpt from "I Will Teach You To Be Rich." At the end of the piece, I offer my thoughts on what's being said here.

If I invited you to a blind taste test of a $12 wine versus a $1,200 wine, could you tell the difference? I bet you $20 you couldn’t. In 2001, Frederic Brochet, a researcher at the University of Bordeaux, ran a study that sent shock waves through the wine industry. Determined to understand how wine drinkers decided which wines they liked, he invited fifty-seven recognized experts to evaluate two wines: one red, one white.

After tasting the two wines, the experts described the red wine as intense, deep, and spicy—words commonly used to describe red wines. The white was described in equally standard terms: lively, fresh, and floral. But what none of these experts picked up on was that the two wines were exactly the same wine. Even more damning, the wines  were actually both white wine—the “red wine” had been colored with food coloring.

Think about that for a second. Fifty-seven wine experts couldn’t even tell they were drinking two identical wines.

There’s something we need to talk about when it comes to experts. Americans love experts. We feel comforted when we see a tall, uniformed pilot behind the controls of a plane. We trust our doctors to prescribe the right medications, we’re confident that our lawyers will steer us right through legal tangles, and we devour the words of the talking heads in the media. We’re taught that experts deserve to be compensated for their training and experience. After all, we wouldn’t hire someone off the street to build a house or remove our wisdom teeth, would we?

All our lives, we’ve been taught to defer to experts: teachers, doctors, and investment “professionals.” But ultimately, expertise is about results. You can have the fanciest degrees from the fanciest schools, but if you can’t perform what you were hired to do, your expertise is meaningless. In our culture of worshipping experts, what have the results been? When it comes to finances in America, they’re pretty dismal. We’ve earned failing grades in financial literacy—in 2008, high school seniors correctly answered a gloomy 48 percent of questions on the Jumpstart Coalition’s national financial literacy survey, while college seniors answered only 65 percent right. We think “investing” is about guessing the next best stock. Instead of enriching ourselves by saving and investing, most American households are in debt. And the wizards of Wall Street can’t even manage their own companes’ risk. Something’s not right here: Our financial experts are failing us.

When it comes to investing, it’s easy to get overwhelmed by all the options: small-, mid-, and large-cap stocks; REITS; bonds; growth, value, or blend funds—not to mention factoring in expense ratios, interest rates, allocation goals, and diversification. That’s why so many people say, “Can’t I just hire someone to do this for me?” This is a maddening question because, in fact, financial experts—in particular, fund managers and anyone who attempts to predict the market—are often no better than amateurs. They’re often worse. The vast majority of twentysomethings can earn more than the so-called “experts” by investing on their own. low-cost funds (which I’ll get to in the next chapter). So, for the average reasons for this that I’ll detail  below, but I urge you to think about how you treat the experts in your life. Do they deserve to be put on a pedestal? Do they deserve tens of thousands of your dollars in fees? If so, what kind of performance do you demand of them?

In truth, being rich is within your control, not some expert’s. How rich you are depends on the amount you’re able to save and on your investment plan. But acknowledging this fact takes guts, because it means admitting that there’s no one else to blame if you’re not rich—no advisers, no complicated investment strategy, no “market conditions.” But it also means that you control exactly what happens to you and your money over the long term.

You know what the most fun part of this book is for me? No, it’s disbelieving e-mails I’m going to get after people read this chapter. Whenever I point out how people waste their money by investing in below-market returns, I get e-mails that say, “You’re full of it.” Or they say, “There’s no way that’s true—just look at my investment returns,” not really understanding how much they’ve made after factoring in taxes and fees. But surely they must be making great returns because they wouldn’t continue investing if they weren’t making lots of money . . . right?

In this chapter, I’m going to show you how you can actually outperform the simplest approach to investing. It’s not easy to learn that reliance on so- called “experts” is largely ineffective, but stick with me. I’ve got the data to back it up, and I’ll show you a simple way to invest on your own.

More Examples of How “Experts” Can’t Time the Market

Pundits and television shows know exactly how to get our attention: with flashy graphics, loud talking heads, and bold predictions about the market that may or may not (in fact, probably not) come true. These may be entertaining, but let’s look at some actual data.

Recently, Helpburn Capital studied the performance of the S&P 500 from 1983 to 2003, during which time the annualized return of the stock market was 10.01 percent. They noted something amazing: During that twenty-year period, if you missed the best twenty days of investing (the days where the stock market gained the most points), your return would have dropped from 10.01 percent to 5.03 percent. And if you missed the best forty days of investing, your returns would equal only 1.6 percent— a pitiful payback on your money. Unfortunately, we can’t know the best investing days ahead of time. The only long-term solution is to invest regularly, putting as much money as possible into low-cost, diversified funds, even in an economic downturn.

USELESS NEWSLETTERS. A 1996 study by John Graham and Campbell Harvey investigated more than two hundred market-timing newsletters. The results were, shall we say, unimpressive. “We find that the newsletters fail to offer advice consistent with market timing,” the authors deadpanned as only academics can. Hilariously, by the end of the 12.5-year period they studied, 94.5 percent of the newsletters had gone out of business. Not only did these market-timing newsletters fail to accurately predict what would happen, but they couldn’t even keep their own doors open. Get a life, market timers.

I’ll end with a couple of more recent examples. In December 2007, Fortune published an article called “The Best Stocks for 2008,” which contained a special entry: Merrill Lynch. “Smart investors should buy this stock before everyone else comes to their senses,” they advised. They obviously weren’t counting on it being sold in a fire sale a few months later. And in April 2008, BusinessWeek advised us, “Don’t be leery of Lehman.” I’m not sure about you guys, but I’m leery of worthless risky advice couched in cute alliteration. I think I’ll ignore you from now on, pundits.

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My (random) thoughts:

1. Oh, boy! He's speaking my language now! Financial "experts" can take many forms -- from the TV personalities who don't know much about what they're talking about to the everyday financial planner who thinks he can manage your money better than you can.

2. Generally, I don't put much stock in financial "experts." In fact, one of my very first posts was about how I didn't really like them.

3. Here are a few of my selections on what I've said about financial planners:

• Shocker: Many Brokers Give Bad Advice

• Many Taxpayers Get Burned by Inept or Crooked Preparers

• Make Sure Your Financial Advisor is Not a Loser

• FMF Speaks: My Thoughts on Using Financial Planners (Or "Why I Don't Go to a Fat Doctor")

• Comments: FMF Speaks: My Thoughts on Using Financial Planners (Or "Why I Don't Go to a Fat Doctor")

• MND: How to Choose a Financial Advisor

• MND: Operate Your Household Like a Business when Hiring a Financial Advisor

• MND: Hiring the Wrong Financial Advisor is Bad for Your Net Worth

• Safeguard #1: Do Not Allow Your Advisor to Have Custody of Your Investments

4. It's very true that becoming wealthy is rather simple (but not easy, mind you.)

5. Just got this book in the mail: How a Second Grader Beats Wall Street: Golden Rules Any Investor Can Learn Here's the Amazon summary of it:

Investing is simple, but never easy. We carry a lot of investment baggage—including hot tips from friends and the financial media and complicated financial recommendations from Wall Street salespeople and brokers. Yet the biggest obstacle we face by far is our ability to outsmart ourselves.

In order to overcome these obstacles, investors need to follow straightforward strategies that will consistently push their portfolios ahead of the pack by an additional three to four percent annually over most investors. Strategies that even a kid could understand. In How a Second Grader Beats Wall Street, readers will follow the story of Kevin Roth—an eight-year-old who was schooled in simple approaches to sound investing by his father and expert financial planner, Allan Roth—and discover exactly how simple it can be to successfully invest. Page by page, readers will learn how to create a portfolio that can move up their financial freedom by 10-15 years. And all this can be accomplished by using some simple, commonsense techniques. Kevin and his dad reveal fresh, new approaches to investing, along with some of the tried-and-true existing but rare approaches. Whether new or old, these techniques share something in common—they're so simple, an eight-year-old can understand them.

Engaging and insightful, How a Second Grader Beats Wall Street: Golden Rules Any Investor Can Learn takes investors through Kevin Roth's story, while driving home key strategies and tools investors can implement in their own portfolios.

6. It turns out that monkeys are also good financial experts.

7. So if second graders and monkeys are good at managing money, you think maybe you can be too (with a little effort) or do you need an "expert" to tell you what to do? ;-)

8. All this said, I do use experts in cases of extreme complexity -- like CPAs and lawyers. The key to using them: make sure you get a good one. Duh! ;-)

Comments

[MonkeyMonk]

I do think having a financial advisor can be useful -- especially if you're a new investor who is bewildered by all the possible financial vehicles.

A financial advisor can be helpful in helping set up a long-term, low-cost, diversified portfolio and then help you keep to your goals and revise those goals when necessary. That's really it. All this shouldn't take more than 4-6 hours of work per year so if you're paying your advisor a lot of money you're probably not getting you moneys worth. Eventually, after a number of years, if you think you've gotten the hang of it you can start to phase the advisor out until you're not using them at all.

[Sarah]

Most of Ramit's point here I agree with (is there a bigger scam than mutual fund managing out there? Well, maybe I shouldn't ask that question), but this:

"there’s no one else to blame if you’re not rich—no advisers, no complicated investment strategy, no “market conditions.”"

When even the big indexes are down 30-40%, um, yes, probably you *can* blame market conditions.

[Dave]

Well, I guess I'm the lone voice of opposition in this blog. I've said this many times in the past. I also strongly believe that stock picking is a useful (and ultimately money losing) endeavor. However, I am a strong advocate of technical analysis and Elliott Wave theory. Of course not everyone can use these tools to get wealthy (as you say, it's simple but not easy). But I have personally used these tools over the past 12 months to do very well.

[Dave]

Oops, what I meant to say was that stockpicking was a useLESS and money losing endeavor. UseLESS not Useful.

[Apex]

I generally agree with this post and definatley find most financial advisors to be useless. Many financial advisors are actually just paid salesman. Often times they were selling shoes, or vacuum cleaners or whatever else they sell in a previous job. They don't have to be any kind of financial expert and many are not. Some are very versed in finances but often even then, they don't have much good advice for you.

I loved the first Ramit post here and was the first to say it but unfortunately he hit one of my hot buttons that sends me through the roof when he mentioned the missing the top 20 or top 40 days of the stock market. I absolutely hate this argument. In financial terms, I consider it the equivalent of "bringing out the Hitler argument." Once you mention this argument of missing the top 20 days of the market you have lost on the merits of the debate regardless of if your other points were valid.

It sounds really good when you say it and thats why so many anti-market timers run to this argument, but it so easy to show how rediculous it is. So in this example if you miss the top 40 best days of the market your return goes from 10% to 1.6%. Think about what this means. That means this market timer got out of the market the day before every one of these 40 best days and back in the next day. This is the best market timer in the history of the world. This scenario is a complete straw man. No market timer would ever behave like this nor could they if they wanted to, because if they could they disprove the theory that you can't time the market. Someone who could perform this poorly clearly did time the market, they just made the exact wrong move instead of the exact right move.

So on its face the idea of missing the top 40 days is really quite silly. But beyond that there is an even more important reason why this is a terrible argument. There are all kinds of market timers and many get in and out around longer time frames. Think about the last 6 months of the market. When you have had the biggest down day in a month or 3-4 big down days in a row, what often happens? It is followed by 2-3 of the biggest up days within a few days or weeks. This also works with big up days followed by big down days. So if this person is moving out of the market because they are timing it, are we supposed to believe that after an 8% up day or 3 days that total a 15% up move they are now going to get back in? No, they are going to stay out and likely there will be a pull back, and they will have missed 1 or 2 of the 40 biggest up days as well as 1 or 2 of the 40 biggest down days and it won't have near the impact that these numbers imply.

It's interesting that when this argument is made you always miss the 40 biggest up days but apparently you get in on all the big down days. So the point is this argument is all for show and bares no relation to what would happen in reality. Under no circumstances would a market timer ever experience anything remotely close to the scenario describe by missing the top 40 up days. And again, if he did, he actually disproves the theory because he is a great timer.

So what is the point. Concerning timing, I think many people think of day traders, hopping in and out of stocks, going for the quick buck, etc. But there are many kinds of timing. There are times when you can make logical choices about things being valued improperly. That doesn't mean that they must return to proper valuations quickly but it does mean that an informed rational person can decide not to play a game that is stacked against him.

For instance, people buying houses that had appreciated 2-3 times in value in 2004-2006. It is not hard to argue that those were unwise choices fueled by a - just do what everyone else is doing mentality. I predicted the demise of the housing market for years before it happened. I knew plenty of people buying rental real estate with negative cash flow because of the appreciation. I told them they were crazy and that this rise was unprecedented in real estate history and it had to correct. They told me I was leaving money on the table and always gave me some argument about houses never dropping in value. I think rational timing analysis says it was not worth the risk. I am now buying rental real estate for 1/2 of what it sold for in 2007. I call that successful timing that you can rationally analize. And if housing just kept going for another 10 years it was still an improper risk reward ratio. The timing said this asset class has surpased its intrinsic value.

I also pulled all of my investments out of the stock market in August of 2006 when the DOW was at 11,500. It went to 14,200 over the next 14 months. I missed some of those 40 biggest up days. I also missed some of the 40 biggest down days. And I never once considered going back in because the P/E ratios were climbing again back to numbers far above historic norms and the economy was hyper inflating on housing and commodity bubbles propped up by debt and it made no sense to me that any of it was real or could last. I started moving some of my money back in at around DOW 9000 and more at 8000 and 7500, but still have a lot out too. I am easing back in as things find their base. I call that analyzing the risk/reward ratio and deciding that if I could get 5% at ING (which I could then) that was better than the chance of 10% in the market when I thought it could potentially go down 25%. And of course it went down more but I make no predictions on that, just that the risk reward ratio wasn't right and now its starting to get more favorable again.

My point is not to prove I can time the market but to say there are times when the risk/reward ratio is skewed and you find it safer not to play in their game until the scales are more balanced. I consider that the kind of timing that is worth analyzing.

Using the argument of missing the best 40 days is unfortunatley a cheap trick argument that misleads people by its powerful numeric results. I think it actually fools a lot of people making the argument into thinking it's a good argument because it looks so powerful. There are good arguments to be made against timing, but the top 40 days argument is definitley not one of them.

[Dana]

Umm, I agree with the general gist of the article. But financial planning, when done right, is essential and important. The important thing is to find the right planner for you. A little knowledge of financial planning and investing doesn't hurt either.

[james]

The shorter "I Will Teach You To Be Rich":

"Wanna get rich? Screw the experts! Because all you need is my expertise."

Like Apex shows with great clarity, Mr. Sethi's basic argument against "timing" the markets involves perhaps the ultimate timing of the markets, albeit of a bad sort!

He claims to take apart all these so called "market timers," but he gives no names, mentions no timing strategy other than -- as Apex shows -- a market timing method that gets you out the day before the biggest % daily rallies in history, and gets you buying the moment these one day wonders have run their course!

Mr. Sethi's basic point:

"Unfortunately, we can’t know the best investing days ahead of time. The only long-term solution is to invest regularly, putting as much money as possible into low-cost, diversified funds, even in an economic downturn."

What's curious about this piece of investing acumen is the implicit assumption it makes regarding the "timing" and the "pricing" of the market. In short, his claim is over "time," the stock market invariably rises.

But what if that wasn't always the case? What if, over time, markets decline? The history of capital is filled with instances where markets move lower over time, and often for a long time, before bouncing back, if they bounce at all. Do you think there is some family in the Netherlands sitting on some rare tulip bulb waiting for prices to recover from the great tulip bulb mania of the late 17th century? In the grand scheme of things, is a tulip bulb intrinsically worth less or more than a stock certificate?

Fact is, 98% of all publicly traded companies in the United States have ceased to exist. Under this formula, buying a stock and holding forever is a recipe for insolvency.

But then again, Mr. Sethi advocates purchasing "low cost, diversified funds" -- which are, of course, run by financial experts who get paid big bucks to risk YOUR money -- so problem solved, and irony be damned.

In short, everyone who invests their own money needs to think of markets as unfolding along a price axis AND a temporal axis. Half the battle is figuring out when something is cheap or expensive; the other half is determining WHEN to buy or sell. I'm not saying you can do both, and you will invariably get one or the other wrong. But don't let that discourage you from striving to understand the interplay of price and time in capital markets.

[Dave]

FMF,

As Apex and James's response make clear, the "buy and hold" strategy of investing has been under attack recently as never before. Rather than serving as a mouthpiece for another personal finance guru's editorial on why "buy and hold is best for the long run," I strongly suggest that you do a SERIOUS and IN-DEPTH investigation of "buy and hold" versus other market strategies over long, long periods of time. I think that will not only be extremely useful for your readers, but may lead to a paradigm shift on how you look at investing.

[FMF]

Dave --

Sounds like you have a passion for this issue. Maybe you'd like to write a serious and in-depth piece on it? If so, contact me and we can discuss.

[Denis Kristanda]

Financial Planning is absolutely essential, but you don't need any Financial Planner. Everybody need to educate themselves to handle and take care of their own money. If one choose to not to do it themselves, then they cannot complain about their financial planner. It's your money, it's your own responsibility.

[Kathleen Rake]

I'm curious about M. Brochet and his "study." I'm not a wine expert, but I am a perpetual student of wine and I've never heard of the study. Where can I go to read more?

[Matt]

Skepticism is certainly just with a lot of folks working in the financial services industry. As a Certified Financial Planner TM, I agree that a bunch of vital planning is certainly feasible without having the need to speak with an "expert". Proof that this is evident is watching Suze Orman repeatedly bash moronic callers for asking her advice on whether it's okay to buy that $25k car despite the fact that they don't have an emergency cash reserve much less a job. On the other hand, for those running a fee-for-service practice charging reasonable amounts for their work, I like my odds of constructing a better, non-vanilla financial & investment plan while justifying my cost through actual results vs. a do-it-yourselfer (not to mention having the self-discipline to follow it, modify it, and adhere to it closely) It's a probability game where the odds run in your favor when your knowledge base is wider and confidence to make tough decisions is required using practical applications. Many people knew the market was overheated in 05, 06, 07 yet still didn't have the knowledge or guts to best exit in an appropriate fashion (i.e. usage of covered calls, collars and other tools you can torch yourself with if used incorrectly). The bottom line is it's ridiculous to generalise stock pickers with true planners and even more ridiculous to assume they all operate in the same fashion.