Over time we develop short cuts, rules of thumb, to make decisions in complex and uncertain environment. The short cuts we take almost never result in the best decisions, but most of the time they are good enough.
Sometimes we try to make the absolute best decision, and we end up paralyzed. To avoid the paralysis by analysis, we often decide that good enough is good enough. If we were as rational as many of the classic economic models assume, we would take all the relevant information, study it, and make the optimal decision for each given circumstance.
Let me share an example that I heard from Andrew Lo of MIT:
Each morning I have to select a specific set of clothing from my closet. I have five jackets, 10 pairs of pants, 20 ties, 10 shirts, 10 pairs of socks, four pairs of shoes, and five belts. How many unique combinations do I have to choose from? Exactly 2,000,000! Now suppose it takes one second to evaluate each of these combinations. In my case, a complete evaluation of all my choices – which is required if I am going to make the BEST decision – would take 23.1 days!
I am sure that we all get dressed faster than that. We simply decide on something to wear that will be good enough.
As we have evolved, we have learned to make choices quickly and in the midst of uncertainty. This process of taking mental short cuts is called heuristics. As well as the heuristic decision making process has served us in terms of avoiding death by saber tooth tiger, it causes some major problems when it comes to investing. One of the most notable is representativeness.
Representativeness refers to our tendency to try to make sense out our environment by looking for patterns in the recent past and then projecting them into the future. Up until six days ago, (see what I mean by short term) we had all forgotten that good things happen. We had decided that because the news was all bad two weeks ago it, will be bad forever. When it is snowing outside, it is hard to believe that it will ever be spring.
Think about this for a moment: does it make any sense at all that when the S&P 500 was over 1,500 in early 2000 that we were refinancing our houses to invest in internet stocks? Look at the chart of the NASDAQ. At the time, everything was good. The news was good. CNBC said it was great your neighbor bought his own island with the proceeds of the latest dot com IPO. Can you remember what was said about the “old timers” that dared to question the new economy? Does it make any sense that late 1999 was a great time to buy, and now is a great time to sell?
Please understand, I am not suggesting that you buy right now. In fact, there might be legitimate reasons to sell now, but that is a decision best made in the context of a financial plan and clearly beyond the scope of this discussion. I am simply saying that we need to be aware of the process we are using to make the decision.
Just make sure that you are not falling for the classic behavioral finance illusion of representativeness.
{ 14 comments }
This is fascinating and really makes a lot of sense. I've been trying to focus on my larger financial plan, but I find myself obsessed with learning about how we got to where we are.
Carl, truly awesome post!
This is fascinating and really makes a lot of sense. I've been trying to focus on my larger financial plan, but I find myself obsessed with learning about how we got to where we are.
Carl, truly awesome post!
Carl,
I appreciate your illuminating explanation of heuristics — something I believe more people should be aware of…
Self-awareness and self-knowledge are key ingredients to success in any endeavor and our brain's use of heuristics, for better or worse, is fundamental to our decision making process.
As you stated, heuristics worked quite well for primitive man. The human brain, however, has not significantly changed in 100,000 years but our environment certainly has dramatically evolved.
Complicating matters for modern man is the incredible amount of external distractions and overwhelming number of choices available for every decision.
If one takes a moment to think about it, the saber-toothed tiger is much less frightening than the environment we live in today.
“Thought is the organizing factor in man: intersected between the 'causal' primary instincts and the resulting actions.” -Albert Einstein
“In character, in manner, in style, in all things, the supreme excellence is simplicity.” ~ Henry Wadsworth Longfellow
Carl,
I appreciate your illuminating explanation of heuristics — something I believe more people should be aware of…
Self-awareness and self-knowledge are key ingredients to success in any endeavor and our brain's use of heuristics, for better or worse, is fundamental to our decision making process.
As you stated, heuristics worked quite well for primitive man. The human brain, however, has not significantly changed in 100,000 years but our environment certainly has dramatically evolved.
Complicating matters for modern man is the incredible amount of external distractions and overwhelming number of choices available for every decision.
If one takes a moment to think about it, the saber-toothed tiger is much less frightening than the environment we live in today.
“Thought is the organizing factor in man: intersected between the 'causal' primary instincts and the resulting actions.” -Albert Einstein
“In character, in manner, in style, in all things, the supreme excellence is simplicity.” ~ Henry Wadsworth Longfellow
There seems to be a lot of introspection right now. Wondering how we
got here and if we shoul have (or could have) seen it sooner.
The problem with recognizing that there was no way to see it coming
(before the fact) is that it makes you wonder if there is anyway to
avoid repeating it.
Really interesting questions…
There seems to be a lot of introspection right now. Wondering how we
got here and if we shoul have (or could have) seen it sooner.
The problem with recognizing that there was no way to see it coming
(before the fact) is that it makes you wonder if there is anyway to
avoid repeating it.
Really interesting questions…
I'm almost thinking you're comparing apples and oranges.
When we select stuff out of our closet, we've already bought the clothes and put them there so we know what we've got. We even have a background of knowledge of what clothes go on what body parts and what 'matches'. But when my fiancee asks me to suggest something to wear, i'm stupefied because there's so many options that i'm overwhelmed by the choices.
I think the new investor (under 5 years) is faced with the same kind of situation that i face when i have to choose clothes for my fiancee: an experience of overwhelm. If you're new to the market, i tell everyone to get a spider (S&P index for those not in the know) and sit on that for a few years. It literally takes years to know how to interpret trends and pick stocks, just like it takes years for little boys to pick out their own clothes (see numerous pictures of little boys wearing superman underwear over their jammies with pirate hats and bunnie slippers)
two notes:
1. Representativeness has failed miserably, ask Nicholas Taleb.
2. I'm also waiting for your general description of the process of financial planning.
I'm almost thinking you're comparing apples and oranges.
When we select stuff out of our closet, we've already bought the clothes and put them there so we know what we've got. We even have a background of knowledge of what clothes go on what body parts and what 'matches'. But when my fiancee asks me to suggest something to wear, i'm stupefied because there's so many options that i'm overwhelmed by the choices.
I think the new investor (under 5 years) is faced with the same kind of situation that i face when i have to choose clothes for my fiancee: an experience of overwhelm. If you're new to the market, i tell everyone to get a spider (S&P index for those not in the know) and sit on that for a few years. It literally takes years to know how to interpret trends and pick stocks, just like it takes years for little boys to pick out their own clothes (see numerous pictures of little boys wearing superman underwear over their jammies with pirate hats and bunnie slippers)
two notes:
1. Representativeness has failed miserably, ask Nicholas Taleb.
2. I'm also waiting for your general description of the process of financial planning.
Byron-
I think we are on the same page. Human's have a created heuristic tricks for dealing with the complexity we face.
One of the tricks is representativeness (using the recent past, looking for a pattern, and projecting it forward).
It may have it place in the world, but when it comes to investing representativeness has failed us. It does not work to assume that the recent past is going to continue.
Buy SPY is a great idea. Buying SPY in January 2000 with money we borrowed against our home because we think it is going to continue to go up because thats what it did last year is a BAD idea. Selling SPY now, for the sole reason that it has gone down in the recent past is another bad idea.
Please keep reminding me that you want to hear about planning, I will get to it soon.
Byron-
I think we are on the same page. Human's have a created heuristic tricks for dealing with the complexity we face.
One of the tricks is representativeness (using the recent past, looking for a pattern, and projecting it forward).
It may have it place in the world, but when it comes to investing representativeness has failed us. It does not work to assume that the recent past is going to continue.
Buy SPY is a great idea. Buying SPY in January 2000 with money we borrowed against our home because we think it is going to continue to go up because thats what it did last year is a BAD idea. Selling SPY now, for the sole reason that it has gone down in the recent past is another bad idea.
Please keep reminding me that you want to hear about planning, I will get to it soon.
I'm almost thinking you're comparing apples and oranges.
When we select stuff out of our closet, we've already bought the clothes and put them there so we know what we've got. We even have a background of knowledge of what clothes go on what body parts and what 'matches'. But when my fiancee asks me to suggest something to wear, i'm stupefied because there's so many options that i'm overwhelmed by the choices.
I think the new investor (under 5 years) is faced with the same kind of situation that i face when i have to choose clothes for my fiancee: an experience of overwhelm. If you're new to the market, i tell everyone to get a spider (S&P index for those not in the know) and sit on that for a few years. It literally takes years to know how to interpret trends and pick stocks, just like it takes years for little boys to pick out their own clothes (see numerous pictures of little boys wearing superman underwear over their jammies with pirate hats and bunnie slippers)
two notes:
1. Representativeness has failed miserably, ask Nicholas Taleb.
2. I'm also waiting for your general description of the process of financial planning.
Byron-
I think we are on the same page. Human's have a created heuristic tricks for dealing with the complexity we face.
One of the tricks is representativeness (using the recent past, looking for a pattern, and projecting it forward).
It may have it place in the world, but when it comes to investing representativeness has failed us. It does not work to assume that the recent past is going to continue.
Buy SPY is a great idea. Buying SPY in January 2000 with money we borrowed against our home because we think it is going to continue to go up because thats what it did last year is a BAD idea. Selling SPY now, for the sole reason that it has gone down in the recent past is another bad idea.
Please keep reminding me that you want to hear about planning, I will get to it soon.
Comments on this entry are closed.