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Holding Court with Stock Market Gurus

| | Posted in: Investing Expertise

Suppose investors/traders were to apply the same standards to a stock market guru that federal courts apply to an expert witness. What, if anything, would they find admissible? Using as a guide the 2003 paper by Jennifer Mnookin and Samuel Gross entitled “Expert Information and Expert Evidence: A Preliminary Taxonomy”, we conclude that:

Federal Rule of Evidence 702, Testimony of Experts, states: “If scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if (1) the testimony is based upon sufficient facts or data, (2) the testimony is the product of reliable principles and methods, and (3) the witness has applied the principles and methods reliably to the facts of the case.” [Underlining ours.]

To determine whether the information offered by a stock market guru is admissible, we focus on four issues for consumers of expert information, as suggested in the paper: (1) validity; (2) competence; (3) clarity; and, (4) bias.

(1) Validity: “Is there a field of knowledge that has credible tools to produce valid answers to questions such as this? …are the methods that were used in this instance capable of producing valid answers?”

The academic community has expended considerable effort to determine whether it possible to beat the market reliably, either through stock picking or investment timing. Disagreement lingers regarding the degree to which market efficiency and randomness rule. Investors/traders must decide whether there is enough systematic market inefficiency to allow excess returns via stock picking or market timing. If no, then they should buy and hold a broad market index. If yes, then a guru can at least theoretically help them.

If the market is somewhat inefficient, do the guru’s methods reliably exploit the inefficiency? Many gurus do not offer enough background on their (secret) methods for an investor to assess their effectiveness. Instead, they present a past performance of unknown accuracy/statistical significance. Sometimes gurus offer a degree of third party verification (“…ranked #1 by…”) with little or no context. Investors/traders should perform discovery and examination regarding methods and past performance claims before ruling on the capability of a guru’s methods.

(2) Competence: “Does the expert…have the knowledge and skill that are necessary to produce the information? …Did the expert…perform competently on this occasion?”

Some stock market gurus have qualifying degrees and/or certifications. Others assert qualification principally based on time served (“XX years of investing experience”).

Examination of guru methods and past performance claims as recommended above mitigates concern about competence. However, a low signal-to-noise ratio (high level of randomness) makes it difficult to draw confident conclusions about both the validity of methods and the competence of individual gurus.

(3) Clarity: “You can only make use of information to the extent that you understand it. …Because clarity seems to have great influence on the evaluation of experts by juries and judges, we are generally willing to rely on…self-interest…to produce clear expert evidence… In fact, a special danger associated with expert testimony is that the…experts will sacrifice accuracy for the sake of appealingly clear but erroneous or over-simplified presentations.”

Financial markets are complex systems, and beating them is not simple and easy. Methods seeking to exploit market inefficiency involve multivariate interplay of risks and rewards. However, for a guru selling services or maintaining customer satisfaction, oversimplification may be tempting. Investors/traders should develop enough knowledge themselves to identify oversimplification and push gurus to achieve clarity despite complexity.

(4) Bias: “…we use various indirect measures of the quality of expert information, of which the most pervasive, in court and out, is bias. …What is the first question that comes to mind when a mechanic at a highway road stop tells you that you need two new tires, immediately?”

A guru selling services may assert market inefficiency, proclaim validity of methods and tout competency (market-beating past returns) in oversimplified (even erroneous) terms. Investors/traders should be prepared to raise objections and ask challenging questions.

In summary, investors/traders should consider a courtroom-like discipline in determining the value of a guru’s advice. It may be that very few stock market gurus would qualify as expert witnesses.

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