One Decision Making Model
Invokes gut feelings or rules of thumb that use your investment intuition!
One decision making model in value investing invokes rules of thumb that use evolved capacities of the brain. These are components of gut feelings
Why gut feelings? What is a discussion of gut feelings doing in a website on value investing?
The reason revolves around the reality that investing in the stock market is a complex process.
It potentially requires the value investor to acquire and bring together a large range of information in order to make optimum buying decisions as to the best stock to invest in.
MORE INFORMATION IS NOT NECESSARILY BETTER!
This became evident to me when I read the book by Gerd Gigerenzer called Gut Feelings: The intelligence of the unconscious.
Gigerenzer argues that a decision making model invoking gut feelings, or intuition by another name, consist of two components ...
- simple rules of thumb (heuristics), which take advantage of ...
- evolved capacities of the brain (that have developed through thousands of years of experience).
The term 'heuristic' is used synonymously with the expression 'rule of thumb'.
When confronted with complex tasks, we humans invoke rules of thumb as a decision making model that attempt to hit on the most important information to make decisions - and ignore the rest.
Gigerenzer provides scenarios to demonstrate the benefits of simplicity that rules of thumb offer ...
"In an uncertain world, using simple rules of thumb as a decision making model can predict complex phenomena as well as or better than complex rules do"
"Less can be truly more under certain conditions."
How I Use Rules of Thumb
I experienced this insight about relying on too much information when I was completing the discussion in this website on stock market screeners.
I was writing about all the things one needs to do before making an investment decision. Then I said to myself at the time - Would anybody do all this before making an investment choice?
More importantly I then thought ... DO I DO ALL THIS BEFORE MAKING AN INVESTMENT DECISION?
The reality is that in some cases I don't. I unconsciously use a rule of thumb, or a heuristic as a decision making model, based on a more limited information set that is not impeded by over-deliberation.
When choosing good stocks I AUTOMATICALLY eliminate companies I choose not to invest in order to reduce my choice to the remainder.
In some cases, such as resources, I limit my choice to the largest multinational companies from the hundreds of resource stocks that are available.
Using a watch list is one way I, and others, control and limit the amount of information that has to be deal with when making investment decisions.
Further Gigerenzer Insights
Another insight that Gigerenzer provides in his book that relates directly to stock investing is to do with asset allocation.
He asks - "when are investment intuitions (gut feelings) better than optimal?"
He goes on to quote Harry Markowitz who received a Nobel Prize in 1990 for his ground-breaking work in optimal asset allocation.
This work demonstrated that there is an optimal portfolio that maximizes return and minimizes risk.
However, Gigerenzer asserts that when Markowitz made his own retirement decisions he did not use this prize-winning technique but instead used a simple heuristic, the 1/N rule, namely ...
Allocate your money equally to each of N funds.
Of course, developing rules of thumb (heuristics) that inform our gut feelings and lead to successful investment decisions require us to sort out the 'wheat from the chaff' in the universe of investment information.
Gigerenzer asserts that the average investor using a recognition heuristic, which implies a limited knowledge of investment 'brand names', can perform as well, if not better, than advisers who have more complete knowledge.
He describes two studies where partial ignorance, rather than extensive knowledge paid.
In further support of this assertion, he argues that there is little evidence that advisers can predict much better than chance.
And he claims that 70 per cent of (U.S.) mutual funds perform below the market in any year - and the ones that do better are flat out repeating the performance!
If you'd like to learn more about decision making and investing, consider a Business Intelligence degree from St Josephs University online.
While gut feelings, as a decision making model, work on a limited set of information, or a beneficial degree of ignorance, I would argue that it takes time and experience to discern what this limited critical information is in any value investing scenario.
My gut feeling is that there is no substitute for the time and effort required to develop this discernment skill!
However, if I had to choose one piece of information on which to base my decision to include a stock in my watch list while waiting for the right price to buy it, it would be return on equity.
Why? Companies that can operate with a high stable or increasing return on equity over a number of years are most likely those with an enduring competitive advantage or economic moat and good management - a winning formula!
Gigerenzer's book provides some interesting insights for value investing. His insights have certainly assisted me in revealing how I think about my own investment thinking!
Stock market screeners
- help to find the best stocks to invest in.
Optimal asset allocation - in a value investing context is about what level of volatility you can handle in your overall investment portfolio.
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