It is only through studying the practicalities of investments that people learn and understand how it really works. Even so, their knowledge and understanding always has its limits, and learning and doing are two very different things.
These issues apply to a greater or lesser extent to almost everyone in the industry - theory and practice are often worlds apart, but many people dangerously treat them as one and the same.
In this article, we will look at what constitutes learning, understanding, experience and real expertise, as well as what sets the limits. The basic issue is that when it comes to investing, there is a huge gap between theory and practice. For this reason, it is important to take a look at the different levels of knowledge and how we achieve them.
The Dangers of Theoretical Knowledge
People who study business or economics in college generally learn passively just to pass exams. Many do not really understand the material until they start teaching the same theories. And even then, this is still just theory. Practice happens when students apply this theory in their personal investing.
Even business professors who write articles in related areas, such as economics, tend to do so theoretically and do not necessarily know much about the real world of investment. In fact, their own investments may be run by other people.
Unfortunately, some types of theory just aren't helpful in practice. For example, although a good theoretical knowledge of economics, should help you learn quickly about real-world investments; unfortunately, the theory alone is of little practical use. Knowing about supply and demand, neoclassical interest rate theory and Keynesian cross diagrams is light years away from the real world of conflicts of interest, commission-hungry brokers and failed attempts at market timing. In other words, these theoretical models often assume the world has very specific and predictable conditions; does this sound like the world you live (and invest) in? (For related reading, see Economics Basics.)
In the world of investment, theory alone can even be dangerous, and this applies particularly to a limited degree of practical knowledge. The old saying that "a little knowledge is a dangerous thing" applies in this context, because it can inspire confidence in the investor, even when he or she has little experience and should be cautious.
The main problem is that the investment industry does not work the way an inexperienced person is likely to think. For example, who would ever dream that many fund managers try to beat an index and fail? How could the man in the street know that brokers may sell risky investments because these bring in the most money? Similarly, naive investors might put too much confidence in their brokers' abilities and assume that they "know what they're doing" without further investigation. Unfortunately, mismanagement is not uncommon, but for an investor with limited experience, this may not be apparent. (To learn more, read Is Your Portfolio Beating Its Benchmark?)
Experience Versus Real Expertise
As you now know, passive knowledge alone does not count for much; you need to actually do things to develop real expertise and skills. Nonetheless, it is also possible to have a lot of experience with something, without having a profound understanding of how it works. (To learn from experienced money managers, read Words From The Wise On Active Management.)
For example, someone who simply works in a bank may administer funds and other assets for years and or decades and not really know much about them. This is particularly the case with routine activities at lower levels. Another danger is that someone who worked with pensions for 20 years may get transferred to hedge funds two weeks before you turn up with your money. This person is then very experienced, but perhaps not in the right area. (For another aspect, see Has Your Fund Manager Been Through A Bear Market?)
The combination of directly relevant experience and various aspects of sophistication is really essential to good money management, both on the part of the investor and his or her broker/advisor. Motivation is also vital. This means being genuinely interested in and caring about your portfolio. If you do your own investing, this may not be a problem, but if you hire a broker, you will need to find one who is motivated to help you. No amount of education and experience counts if it is not applied appropriately. These are complex issues, but they are of fundamental importance. (To learn more, read Is Your Broker Acting In Your Best Interest?)
Knowledge in One Area Is Still Ignorance in Another
Given the extraordinarily wide range of investments, someone who knows a lot about stocks may know (almost) nothing about bonds. And even a government bond expert could be relatively ignorant about the ins and outs of corporate bonds. The term "experienced investor" can therefore be extremely misleading.
Only experience in a specific sector is really likely to help. The extent to which knowledge with one asset class applies to another, for example, is extremely variable and cannot be taken for granted. Therefore, never assume that someone has the right package of skills, experience and expertise to advise or work in a particular field - do your research and determine exactly what experience a professional has and how directly it applies to his or her current line of work.
The Knowledge-Experience Continuum
Given the above, we can divide up private investors into three main knowledge-experience categories:
The Know Nothings. The first category would be those who, for all intents and purposes, know nothing. Almost everyone earns some money and perhaps even invests part of it, but if this is purely passive, uninterested and unmotivated, people can go through their entire adult lives without gaining any real knowledge or understanding of the investment process and what it entails.
- The Know A Littles. The next group would be those with a limited degree of knowledge and experience. This knowledge could be very theoretical, such as from university economics or even some college finance courses, or it could be more practical, from reading newspapers, magazines and books.
Many people fall into this category. They know a bit or even a fair amount about stocks, bonds and real estate, but this knowledge may remain superficial and narrow. They would not necessarily know what constitutes a high versus low-risk portfolio or the difference between a mutual fund and a hedge fund. They still have to rely heavily on the "experts".
- The Know A Lots. Moving on from the above level, there are obviously those with above-average or advanced levels of knowledge and experience. These people have been reading extensively for years, maybe even teaching or writing on investments or have been managing their own money or that of others quite actively. Despite this, they too will inevitably have gaps in their knowledge and experience.
Applying the Continuum to People in the Industry
When it comes to investment professionals, the three groups above still apply, but with some important differences. Professionals are extremely varied in terms of their area(s) of expertise and commitment to customers, so it is important to find out not only how experienced a professional is, but also in what areas. (One aid to evaluating real experience is certifications. Read more in The Alphabet Soup Of Financial Certifications.)
What people really know, understand and can do in the investment industry is absolutely fundamental to managing your money or hiring someone else to manage your money properly. A complex interplay of education, motivation, relevance and sophistication all determine whether an investor or a professional can successfully manage a portfolio. It is therefore extremely important to know who you are really dealing with. This in itself constitutes one of the great challenges of the investment scene. (For more insight into choosing the best advisor, read Advice For Finding The Best Advisor.
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