Heuristics — Edge Comes from the Exceptions

People making decisions under uncertainty in complex situations employ simple rules of thumb or heuristics.  Stock market analysts have taken note of this literature.  Their summaries of it seem to suggest that average investors make mistakes.  What they seem not to realize is that reading the books does not innoculate one from these same human tendencies.  I expect to show that much of Wall Street lore follows these simple rules.  I further hope to show that investors who understand how the rules work, and when there are exceptions, can profit from a contrarian stance.

First, the literature —

There has been tremendous research progress in psychology and decision-making, and much of it has made its way into the literature on Behavioral Finance.  I applaud the work of Daniel Kahneman and others.  It has been an interest of mine since my early college days and I studied much of the early literature in my dissertation research.

I have especially appreciated many of the recent works that have applied the findings to topics of my daily interest.  At some point I’ll figure out how to list the books on this site, but they include books like How We Know What Isn’t So, Why Smart People Make Big Money Mistakes, Inevitable Illusions, and a number of others.  I’ll try to put up a more complete list of what I have studied.  A favorite, related more to the entire research process, is Fooled by Randomness, which I sent to many of my favorite clients.

Now why is this important?

It is a widely accepted notion that markets discount information quite effectively.  Some believe in various levels of the efficient market hypothesis.   If markets were in fact completely efficient, most of us in the investment business would be charlatans!

Experts in fields requiring decision-making know all of the heuristics, but they also know the underlying causal models.  They know when to make exceptions.  They know when to say "Things are different this time."

In one of my worlds, high-level tournament bridge, many of the competitors are experts at stocks, options, and other derivatives.  They are highly skilled at analyzing risk and reward, doing so quickly,  and acting under pressure.  Bridge has a large number of heuristics that help beginning players learn how to play at an adequate level, avoiding serious error.  There is a point count system for evaluating hands.  There are rules of play like "second hand low,"  "third hand high," lead up to weakness," and "cover an honor with an honor."

Blindly following these rules might help a player achieve average in a Flight C game, but that is about it.  Experts understand that these rules usually work, but each case is tested to see if "this time is different."  When  you see a hand in a bridge column, the expert player popped an honor second hand, or ducked as third hand, or whatever.

Perhaps readers can suggest similar concepts from other intellectual activities requiring heuristics.

The point is that knowing the basic rules of the stock market like The Presidential Cycle, Don’t Fight the Fed, Three Steps and a Stumble, or other similar slogans is only enough to make you average in the Flight C game.  These are universally known market concepts that should be fully discounted by current market prices.

If one wants to find edge, one needs to know, for example,  why the Presidential Cycle seems to be relevant.  What is behind it?  What is the cause?  Should we expect it to be in force right now, in 2006?

Is the Fed tightening just like those from history?  Is the Eisenhower experience relevant?  Does it matter what the starting and ending rates of the tightening cycle are?

These are questions that I will explore in the upcoming weeks.