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Why Willful Ignorance Trumps Expertise in Investing

Moneywatch is currently running a feature package entitled What's Next for the Markets? In it three very well-credentialed experts -- Diane Swonk, David Winters, and James Paulsen -- offer their thoughts on what the future has in store for the markets. Each has an impressive resume, and has spent years following the markets. Each lays out a well-reasoned and logical explanation supporting their expectation for the market's direction over the near-term. And each foresees something different.

Of course, that shouldn't be a surprise. Trying to predict what the future holds for the stock market is a mug's game under the best of circumstances. Throw in unprecedented volatility, a crushing recession, a burst housing market, and historic levels of debt, and, well, there's lots of room for interpretation.

This isn't to impugn the opinions of any of the experts. But the fact of the matter is that you should take anyone's stock market predictions with a rather large grain of salt. Yet I, like many investors, am always a sucker to read what some expert thinks might lie ahead.

Why is that?

At a very basic level, part of it likely stems from our desire to try to wring some semblance of logic out of the seemingly irrational movements in the market. Investors are pattern-seekers, searching for correlations and causes in the random movements of the stock market. And the knowledge that sector X has led the market out of four of the past five recessions, for instance, appeals to us for the same reason that some lottery players actually pay money to have "experts" pick their numbers for them -- we're sure there's a pattern there, and if we can only decipher it, we can make money off of it.

Another part of it is likely attributable to the same trait that causes so many investors to dedicate so much time, effort, and money to trying to pick a winning mutual fund manager: we value expertise in every other area of our lives, so why should investing be any different?

In just about every other profession -- law, medicine, accounting, and so on -- there's a very strong link between the price you pay and the value of the expertise you get. If you were involved in the trial of the century, you'd surely want someone like David Boies representing you instead of the first name you found in the Yellow Pages. You'd expect Boies to increase your odds of success, justifying the healthy premium you'd pay for his services.

So many investors listen to the experts, act on their advice, even hire them to invest their money, based on the hope that the expert counsel will increase their odds of success. But volumes of historical evidence clearly demonstrate how futile that hope is. It turns out that expertise doesn't pay dividends in the financial markets.

How can that be?

For one thing, outperforming the market is a zero-sum game -- for everyone that wins, there's someone else who loses. Those thousands of highly intelligent experts, all poring over mountains of data in an attempt to gain an edge over their competitors end up canceling each other out in the aggregate. The expert on CNBC touting technology stocks as a screaming bargain is purchasing those stocks from another investor who thinks they're overpriced. Both can't be right.

Exacerbating the problem is the price we pay for investment expertise. Because investing is a zero-sum game, investors as a group earn the stock market's return before costs. But after we deduct the inflated prices we pay fund managers to swap stocks back and forth with one another on our behalf, investors as a group end up trailing the market's return by the amount of those costs.

Because of this math, successful investing requires a bit of counterintuitive thinking -- declining to pay for expertise, minimizing your expenses, and thus maximizing your share of the market's total return provides you with an above-average return. Willful ignorance trumps expertise.

It's fine to read opinions, of course, and consider the many arguments about what the market is doing to do over the coming months. But remain agnostic, and refrain from acting upon anyone's prediction -- no matter how well-reasoned it seems. Instead, create a low-cost, broadly diversified, balanced portfolio that will allow you to meet your long-term goals regardless of whether the short-term bears or bulls are ultimately vindicated.

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