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July 20, 2014

Does More Experience Bring Better Return?

By Charles Rotblut

If you listen to Malcolm Gladwell, you might believe spending 10,000 hours on investing will help you make better portfolio decisions. In his bestselling book, "Outliers" (Little, Brown and Company, 2008), Gladwell cites data from a study linking hours practiced to expertise. Gladwell’s assertion of the number of hours required to gain mastery of a skill is based on a 1993 study of violinists by K. Anders Ericsson and colleagues at Florida State University. The best violinists practiced 10,000 hours, 2,500 more hours than other violinists, according to the Ericsson group.
The Ericsson et al. study is widely cited. If one were to extrapolate its results, a link between the amount of time spent investing and portfolio returns could be drawn. Similar links could be drawn between practice and other activities as well. This is not the case, however. A study recently highlighted by Business Insider argues the amount of practice actually only plays a small role in the mastery of a skill.

In “Deliberate Practice: Is That All It Takes to Become an Expert?,” six researchers analyzed the data from many studies on chess and music. The researchers describe these activities as the “the two most widely studied domains in expertise research.” They found deliberate practice only accounts for 34% of variance in chess performance and 29.9% of variance in music performance.
The six researchers further directly counter Ericsson’s (and thereby Gladwell’s) assumption that a certain number of practice hours leads to mastery. The researchers opine, “Some normally functioning people may never acquire expert performance in certain domains, regardless of the amount of deliberate practice they accumulate.” Extrapolate this statement to investing and it can be concluded that the amount of time spent analyzing securities and the market doesn’t guarantee higher returns.
Making such an extrapolation may not be a stretch. In a study of Taiwanese day traders, those with as much as 10 years of experience still lost money. If decisions with a low probability of producing success are consistently made, failure will follow, regardless of how many hours are logged.
There are certainly many other factors at play when it comes to investing. One of the biggest is the ability to consistently set aside emotions and act in a rational manner regardless what the market is doing. This is far easier said than done. Knowledge, particularly an understanding of the factors associated with long-term gains, plays a key role. So does following a disciplined, well-thought-out approach. Cognitive abilities are another big factor, both from the standpoint of intelligence and from the standpoint of being unimpaired. Luck is a wildcard that can make bad decisions seem good and good decisions seem frustratingly bad. Talent does play a role; some people are simply better at picking investments than others. And, yes, there is a benefit to gaining experience, especially if you are able to learn from what you did right and what you did wrong.
Even if an investor has average levels of investing skill, there are steps he can take to improve his long-term returns. Implementing mechanisms to limit the impact of his emotions is a big one, whether that means using written buy and sell rules or relying on the help of an adviser. Placing greater emphasis on factors historically linked to better returns, such as fundamental strength, attractive valuations, dividends, and even momentum, is also important. Staying diversified limits the blow of bear markets and prevents any one single investment from destroying a portfolio. Finally, it’s critical to focus on the things you can control, constantly focus on the long term and accept the complete lack of control you have over both the direction of the markets and the economy.
The Week Ahead

Second-quarter earnings season will hit full stride with approximately 150 members of the S&P 500 reporting. Included in this group are Dow components Coca-Cola (KO), Du Pont (DD), McDonald’s (MCD), Microsoft (MSFT), Travelers (TRV), United Technologies (UTX) and Verizon Communications (VZ) on Tuesday; AT&T (T) and Boeing (BA) on Wednesday; and 3M (MMM), Caterpillar (CAT) and Visa (V) on Thursday.
The week’s first economic reports of note will be the June Consumer Price Index (CPI) and June existing home sales, both to be released on Tuesday. The next reports will be the July purchasing managers’ manufacturing index and June new home sales, which will be released on Thursday. Friday will feature June durable goods orders. 
The Treasury Department will auction $15 billion of 10-year inflation-protected securities on Thursday.
About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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