According to Wikipedia, heuristics are defined as: any approach to problem solving, learning, or discovery that employs a practical method not guaranteed to be optimal or perfect, but sufficient for the immediate goals. Where finding an optimal solution is impossible or impractical, heuristic methods may be used to speed up the process of finding a satisfactory solution. Examples of this method include using a rule of thumb, an educated guess, an intuitive judgment, guesstimate, stereotyping, profiling, or common sense.”
From my experience investing and dealing directly with investors for over a decade now, I have come to realize that the majority of novice investors, whether they realize it or not, utilize heuristics in their investing process with widely varying degrees of success. For example, the stock market has been in a bull market for a prolonged period of time, and an investor decides to de-risk their portfolio due to the gut feeling that the market is due for a correction. Aside from the obvious flaws in this method of asset allocation, an investor that employs this method will most likely have a streak of success during certain market environments, and will incorrectly attribute any success gained from this method to its efficacy, all further reinforcing negative behaviors.
The Biggest Problem
The main problem I see with this simplified example is that when using heuristics or emotion-based decision (gut feelings), the investor must have similar experiences to benchmark their emotional decision making against in order for this method to have any chance at success. What do I mean by that? I guess what I am saying is gut feelings are only potentially useful when you have a decent sample size and the emotional intelligence to be able to recognize and journal emotional decisions at points in time. If you have a gut feeling that the stock market may be at a potential top but have never experienced a market top previously and instead rely on historical recounts of other people’s emotions during market tops, that gut feeling is just a random emotion-based decision that has no relevance to the stock markets’ behavior.
The Way to Succeed
In my opinion, the way to possibly successfully utilize rules-of-thumb is by chronicling one’s emotion-based decision making over the course of several market cycles. Forcing yourself to record how you feel during various points in both bull and bear markets not only helps you understand yourself, but provides you with a recount as to whether certain emotion-based decision making is positively, negatively (contrarian), or completely uncorrelated from future market performance. Due to the long-term nature of this exercise, it is unattractive to the market participants that lack patience or dedication, and most importantly it requires a high degree of self-introspection which is painful for many. These road blocks provide an opportunity for those willing to focus on the long term and getting to know themselves, both the good and the bad. This humbling process will help you gain humility, which is an invaluable asset when investing.
Rather than relying on something as volatile and prone to external forces as emotions to drive investment decisions, the majority of investors would benefit greatly from developing systematic investing processes that are repeatable and data driven. This doesn’t mean that you have to write complex algorithms to achieve this, but any good investment methodology should be able to be broken down into logical steps and understood by anyone with at least an intermediate knowledge of investing.
My Personal Preference
I personally gravitate towards quantitative methods, but am constantly reminding myself that simplicity is better than complexity. In the infamous “Quant Quake” of 2007, three quarters of Goldman Sachs’s assets destroyed a five-year span following sudden liquidation by a multi-strategy fund or proprietary-trading desk. This event likely caused algos to run awry and ignite fire sales in similar quantitatively contracted portfolios. My belief is that during times of panic, if you cannot dissect your investment process to understand why it may or may not be working, the majority of people would bail. Small mistakes such as falling victim to the allure of complexity, can and will destroy any success you may have had up to that point. Keep it simple out there, folks.