In Finance and Medicine Evidence Beats Reputation

I have practiced medicine for thirty years and have been trying my luck with investing in the market for almost as long. There are some strange similarities between the market and the human body. Both are extremely complex and are an intricate network of interactions of signals, all subject to stimuli from the outside. Both the market and the body produce signs and symptoms. Usually, these symptoms are unimportant. But some may be harbingers of some major illness or, conversely, signs of recovery. To the untrained eye, the important signs may seem trivial and (more usually) the unimportant signs may seem threatening and worrying. I can easily tell these apart in my patients. But I often wish that I had the skills of a “market doctor” and was able to scientifically recognize meaningful signs in the market and take advantage of them.

One can take this analogy quite a bit deeper and make some interesting observations about the nature of expertise. Let’s briefly examine the history of medicine. In ancient times, the practice of medicine was dominated by wise men who were thought to have discovered some secrets and have a special understanding of the human body. They were not asked for any evidence that what they were recommending was safe and effective, nor did they offer any. Their authority was enough. Galen, arguably the greatest physician of antiquity, came up with the idea that bloodletting was a great cure for many diseases. Based on his reputation alone, this dangerous practice became the unquestioned standard treatment for a millennium and a half.

Galen’s equivalent in ancient China was Zhang Zhongjing who based his therapeutic system on the yin yang and the Five Phases. These ideas were derived from philosophy and certainly not from the study of the human body. His authority was unchallenged for centuries (and still remains intact among some practitioners). The idea that medicine should be a science and not just an art is very new. Evidence-based medicine only took root in the last fifty years. Thankfully, in this day and age, most North American doctors would describe their practice as evidence-based.

A very similar evolution has been happening in relation to how the market is interpreted, but a change from authority-based recommendations to evidence-based market analysis seems to be far behind the corresponding changes in medicine.

The investment community is still dominated by gurus, experts, advisors, analysts, “old hands”, TV wizards, oracles and prophets. Very little, if any, of their methodology has ever been tested. We are supposed to take their investment advice based solely on their authority and reputation. Many of their dictums and aphorisms have been quoted from book to book for a century and still abound today despite never having been put to the test. For example, the classic advice always to use stop-loss orders on your positions has never been challenged (until recently – there’s a great discussion on this topic at http://skepticaltradingstrategies.com/index/stop-orders-will-cost-you-money/ )

A while ago, a came across a magazine interview with one of the famous fund mangers, a giant in his field. He was asked to reveal the secret of successful fund investing to the readers of this prestigious publication. And he did. The secret was: select six well managed funds with good long term track record, and invest in the three of them that had the lowest returns in the previous year; then, once a year, rotate your portfolio so as to be always invested in the three weakest funds of the year before. (His logic was that a “well managed” fund would always rebound from a poor year and an exceedingly good return cannot be repeated in the following year). The interviewer never asked if this was ever tested – the reputation of the man was enough. Thousands of readers might have followed this advice and… lost money.

It did not take me long to select several groups of six funds each, collect the data from Yahoo, plug it into Excel and test the guru’s advice for the preceding ten years. The results were the exact opposite of what the great man advocated!. The weak funds tended to remain weak and the winners tended to stay ahead. Did the guru not know this? Or did he try to deceive?

Conclusion: in finance, evidence beats reputation and science beats art.

Article Source: http://EzineArticles.com/?expert=Wojtek_Ciszak

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