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William J. DeRosa, Jr., CFA
William J. DeRosa, Jr., CFA

Heuristics and Investing

March 16, 2010

Most people are unfamiliar with the study of heuristics, yet we use them every day. Heuristics is defined as a common sense rule (or set of rules) intended to increase the probability of solving some problem. A description of this type of cognitive function which might be more familiar to us is known as a ‘rule of thumb’. A great deal of study has been devoted to the understanding of the human cognitive decision making process and how we might optimize our results. As you might anticipate, the parallel to the world of investing is quite noticeable.

Gerd Gigerenzer, a director at the Max Plank Institute for Human Development, has done some pioneering research in this field. He has written a number of books on the subject. In one of his more recent works, Gut Feelings: The Intelligence of the Unconscious, he lays out the framework for his research. His work has revealed many interesting concepts that have to do with how we come to make decisions. For instance, what is an optimal decision-making process? Optimal decision making can be a complex endeavor, especially in the financial markets, which are complex, adaptive and open-ended. One such theory is the “take the best” concept.

The following is an excerpt from the book;

Intuitions based on only one good reason tend to be accurate when one has to predict the future (or some unknown state of affairs), when the future is difficult to foresee, and when one only has limited information. They are also more efficient in using time and information. Complex analysis, by contrast, pays when one has to explain the past and when the future is highly predictable. Animals and insects have been noted to display this type of adaptive strategy behavior. For example, honeybees trained in experiments to identify model flowers rely on a set of cues with odor on the top. They decide on the basis of color only if the odor of the two flowers matches.

Certainly, we have been conditioned to believe that the greater the complexity, the greater the efficacy. However, this may be counterproductive. This is very true when it comes to evaluating our investment process. Most investors are attracted to a process that is complex. If it isn’t than surely we’re not getting our money’s worth. The more charts, graphs, and complicated equations thrown in our face, the better we feel about the approach. Yet this is a short-coming of our own human nature. Perhaps our egos won’t allow us to admit that we simply don’t understand.

How do we apply proper heuristics within the investment process? The answer is a simple and defined set of rules to drive our decision making. Think of it as a muscle memory for your investing. Our biggest problem when it comes to effective decision making is generally ourselves. Rule making procedures which are pre-defined help to take ourselves out of the equation. More often than not, a simple set of rules will often prevent mistakes. For example, if a potential company is profitable it will be considered, otherwise it will be ignored or we will only buy companies that meet our criteria for valuation. It may seem overly simple, but it can be very effective- and that’s what it’s all about.

The study of behavioral finance has become more prevalent – and for good reason. We tend to be our own worst enemy when it comes to investing.

About the author:

William J. DeRosa, Jr., CFA
William J. DeRosa, Jr. is the General Partner of Anthem Asset Management, LLC is an independent investment management company. He has also served as Director of Equity Research and Senior Portfolio Manager at various buy-side asset management firms. Mr. DeRosa is a Chartered Financial Analyst and is a member of The CFA Institute.

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