Valuation, Technical Analysis, and Expertise

Geoff has written an excellent post on the relative merits of fundamental versus technical analysis.His reasoning follows this logic:

1. Quoting Ben Graham, market prices are a function of both reason and emotion, in the long run governed by intrinsic value, and in the short term, somewhat random, governed by emotion.


2. He uses a metaphor that compares the market to a circus fun house mirror, where the ensuing reflection may not be an appropriate representation of the input data. I think this is a brilliant analogy!


3. Since all things are subject to cause and effect (like Newtonian physics,) and since stock price movements are not "uncaused," therefore measuring the effect through methods like technical analysis must have some logical validity if not merit.


4. However, because technical analysis is so interpretive, and because fundamental analysis is empirically more powerful and direct, therefore why dedicate too much time to TA?

I think this is a balanced viewpoint. Many investors seem to use technical analysis well over the short term. Taking advantage of sentiment shifts and over-reaction to news is the realm of behavioral finance and some forms of TA. Relative strength and momentum methodologies have proven themselves from my academic as well as my own research, but as an addendum, an asterisk to my primary fundamental work. Bill R. of NoDooDahs is a very bright blend of valuation guy and technician who seems to be skilled at reading the charts with his predictive models. So where does investment expertise lie?Here is another Michael Mauboussin link that addresses this issue:

Michael Mauboussin

The approach to investing really is best defined by people like Munger, Lou Simpson, Bill Miller, or George Soros. What are the characteristics of expertise?

As MM points out:

When tested, experts appear to have recall capacity that exceeds the limits of short-term memory. While they do not have larger short-term memories than the average person, experts have internalized, and hence made automatic, many basic skills. Deliberate practice assures experts have more patterns stored in long-term memory that they are facile in retrieving.

As well: Experts represent problems at a deeper level than novices.

Applying this to the investment area, MM writes:

Successful investors put in plenty of deliberate practice. In investing, this generally means lots of time reading, often across diverse fields. For example, the highly-regarded head of GEICO’s investments, Lou Simpson, says, “I’d say I try to read at least five to eight hours per day. I read a lot of different things . . .” Berkshire Hathaway’s Charlie Munger makes the point more emphatically, “In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time—none, zero. You'd be amazed at how much Warren reads—at how much I read. My children laugh at me. They think I'm a book with a couple of legs sticking out."

Great investors conceptualize problems differently than other investors. As a group, these experts go beyond the near-term obvious issues, can identify relevant principles because of their experience, and see meaningful trends. These investors don’t succeed by accessing better information; they succeed by using the information differently than others.

Long-term investment success requires mental flexibility. Just as markets constantly evolve, so too must investors. Further, expert investors possess the second type of flexibility—an ability to recognize when their easily-accessible mental models no longer apply.

Not pattern recognition but process recognition. As scientist Norman Johnson notes, in complex systems an expert can create a mental simulation, fueled by diverse information.

My conclusion: Discipline works. Ultimately it becomes second nature and one becomes facile at retrieving. Being an investment “expert” is a long and deliberate process. In my view, becoming a professional investor is the longest apprenticeship in the world. The ability to think deeply based on the application of a variety of mental models, based on the ability to conceptualize problems differently than others, and having the mental flexibility to evolve your process is what ultimately determines the level of achievement one can attain in this vocation.

As Buffett says, there are a lot of ways to get to heaven. Use whatever works for you if you can define it as a discipline!