Why the Expert We Follow Will Go Bust Tomorrow

There are no experts that will make us rich. Here are some thoughts why the strategy one copies is surprisingly likely to go bust tomorrow.

The Problem with the Expert

How can we fool ourselves by following an expert?

It feels good to let someone else do the thinking. And we could sure enjoy some high returns while we follow an investment-wiz, instead of the painstaking 5-8-10 years' slow road of frugal living until we achieve financial independence, right?

Let's say that we have been following some portfolio-wizard for a long time; a stock-picker or investor in some more or less exotic assets.

And by the Gods: is she good! Our guru outperforms the market with 20-30% year after year. Not so much that it's obvious that its a fluke; no - just so good that she Amounts to Being A Very Gifted Investor. 

And, in this hypothetical world, we can't help but to dream away. 

If we keep up with a 20-30% growth year after year we would already be deep into financial independence, sipping sublime pink champagne from a golden bathtub in a glade with the Gods since many years.

Poolparty for the Gods
Diana and Actaeon, Titian 1556-1559 

So we start to get more interested by the guiding light of this sage, and we read ourselves into the details of her thinking.

And indeed, she has a theory. Her ideas are based on bright and piercing observation. It just makes sense. How could such clarity, perhaps tinted with refreshing cynesism, be false? She might even be like us. How wonderful.

After several years of observation - we are overly cautious and conservative, after all - we decide to copy her portfolio.

We've done our homework. And we have the facts to prove it, or so we think, with increasing significance with the evidence accumulated of each successful year. It's a strategy that have been going strong for so long. What could possible go wrong?

The month after we buy into her portfolio composition, the losses are up to 90%. Her webpage and blog disappears, and she is nowhere to be found. And, before we understand what is going on, and because losses are fractal and can happen over and over again, we lose another 90%. 

Our life's savings are now obliterated.

The Expert We Copy Will Loose Everything Tomorrow

When we first read about the expert fallacy in Harry Brown's book about financial safety, a chapter entitled "Don’t expect anyone to make you rich", it seemed contra-intuitive, almost mystical. It smelled like a believe in foresight, a believe in faith; something to be taken as serious as a fortune teller armed with a crystal ball or a quack selling a cure against upset bowels, ill temper and social media addiction. 

How could one possibly know what will fail tomorrow? 

Now the funny part: It's not just the Gods machinating against us for their pleasure. There is math and logic behind this. The example above with the wunderkind investor wasn't as simple as us being unlucky. Just like a magic trick, where reality and our own dreams are the magician; a magician that turns one's expectations inside-out, a trick made by our own brains by wanting to cling to a good narrative.

But there is another, truer perspective. The failure of the expert is much more probable than it might seem at first glance.

The answer lies in the realm of our good ol' friend probability theory, and how she can sneak up on us in unexpected, opaque and subtle ways.

Winner Bias, once again

Apart from the opacity with an investor itself (do we know all about her investments? What are here motivations ? How oblivious to Fortune changing course is she?) But in a larger picture, this fallacy is about winner bias in one of its many disguises and reincarnations.

Many of the 'experts' we see, are just those that happen to still not have blown up. 

We might have been watching a few gurus, and semi-unconsciously lost interest as this or that 'expert' blew up with his or her portfolio. By forgetting about evidence - not to mention all evidence that never reach us - we masquerade the likelihood for ourselves if our a single expert is succesful or not. 

We see only Her, the one that survived, and it's Her that we fall in love with.

In reality, it was never much special with the portfolio of the wunderkind. It just happened to have survived a little longer than the others that went out of the game. And we happened to fashion a narrative around it, a constructed explanation why we liked the portfolio, or the person, or the made-up 'theory', or all of it.

But there was nothing special with any of it. We just got lost with the direction time moves. What one has seen is not what will be in the future.

When we act in the now, we loose this advantage of hindsight, and like a Heisenberg equation around an electron, the probability wave collapses to the observation - or rather, to our action. The strategy that we had been able to cherry pick in a cloud of possibilities, that strategy now become concrete, real. And we no longer has a possibility to cherry-pick. 

And this mountain of self-delusion is build on a truly, non-linear, high price for the risk of the strategy's over-achievement. Hence the dramatic downfall.

There is always someone standing on the battleground of life, and she might seem clever, but all things considered - it might be a question about luck, and it will be very ill-advised to copy her behavior.

Shouldn't We Never Listen to Advice?

What can we do against this? Can we never trust anyone?

Well, we think that it's just hard - we're so sorry to say. And as said over and over again, the easiest person to fool is usually ourselves.

Here are some rules of thumb we try to use:

1. We don't pick individual stocks. We just don't. 
2. We ask ourselves if an idea we have is actually just about chasing higher returns instead of balancing and protecting the downside. 
3. We think that it's very hard to reach above 10% annual growth consistently. And when one does, the risks behind the return are not linear. Then we believe that the hidden risks are much more dire, and can very quickly get us close to ruin and a loss of all our savings. 
4. We try to catch ourselves when we are retrofitting an explanation to past performance. In science, that would be very bad. In investing, it might be even worse.
5. We try to imagine if there might be dead, silent evidence that we are missing.
6. We try to look at similar strategies; did they leave blown-up investors in its wake? 
7. We ask ourselves; would this be good advice if history unfolded differently? Paradigms shift, what would happen if there was a new paradigm tomorrow? 
8. We don't believe in going all in in a single strategy. 
9. We don't tie our savings to a single asset class, and barbell the risks.
10. We try to construct a simple rule or algorithm, linked to the bouquet of strategies we use, and try to figure out if there's true return under different paradigms behind our idea, independent on past performance or a certain future playing out. But even then we don't trust our idea.
11. We test our thinking over a long run of past data. We really do remember the downturn in 1871 here, no kidding.
12. We try our thinking in many different countries, as a proxy for different paradigms and scenarios.
13. And we test even more scenarios that even never really happened, by doing Monte Carlo simulations; by using tools on the net and just building them ourselves.

We will not be the smartest ones out there. In all likelihood, no individual retail investor ever will, even if they might seem to be able to pick stocks or a fancy strategy for a while, even a long while. All that will change as soon as we invest.

So rather than chasing the higher return and dreaming about the divine pool party, we think it's better to waterproof our strategy before trying to join the Gods.