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.

This time it really was different

A couple of weeks ago I was driving around town through a familiar intersection.  Having lived in for fifteen years in  Naperville, a kid-friendly Chicago burb of about 140,000 people, I have driven through this intersection thousands of times.  The light was green, a simple indicator that I could proceed.  On this particular occasion, however, someone was blasting through the intersection, against the light, at a high rate of speed.  As a cautious old guy I have learned not to depend on the simple heuristic of the green light.  The younger Jeff (and a lot of cell-phone gabbing teenagers in my neighborhood) might have had a serious accident.  But since I understood the underlying mechanism of the traffic signal I know that it is only an indicator of probable safety.

Earlier this month I heard the DuPage County sirens go off, indicating a tornado or disaster of some sort.  This is an important warning system, since there have been major tornado disasters a few miles from my home.  We take the warning seriously.  I glanced at the clock and noticed that it was 10:00 AM on the first Tuesday of the month, and remembered that this was the normal monthly siren-testing time.  By understanding the underlying mechanism, I realized that the indicator did not have its normal message.  (Some day there will be a tornado or disaster at exactly that time, but that is another problem).

The point for stock market observers is that there is danger in blindly following heuristics.  By paying attention to the underlying mechanism, called a causal model in social science research, one can avoid mistakes.

I understand that many of my readers behave just as I do in many real-life situations.  The question is whether they take that experience and apply it when they have a question related to the market.  I will provide examples where many Wall Street types show blind adherence to simplistic rules.  In fact, the example occur daily on CNBC faster than I can record them!

Please note the point.  I am not saying that those following the "rule" are wrong.  I am saying that without knowing the causal model, they do not know whether they are wise or blind.

Down with Slogans!

One of my New Year’s resolutions is to wage a war on slogans.  I hope to help my readers to see how they can gain edge through a Contrarian approach to slogans.  This will take a series of posts with different subtopics and examples.  Partly it is my effort to put down pieces of a longer work in progress.  Partly it is inspired by Barry Ritholtz’s excellent series (which I expect will be a successful book at some point) The Apprenticed Investor.  You can and should read these articles.

So what is my mission?  Here is a typical conversation among those analyzing the market.  It may occur on CNBC, on professional sites, on blogs, or on forums.

A:  I think that this is not like a typical Fed tightening sequence (or inverted yield curve, or economic recovery cycle, or energy spike, or trade deficit, or many other things).

B:  Are you suggesting that something is different?

A:  Well, it does seem to be different…..

B:  Gotcha!!  You said the magic phrase, "It’s Different this Time."  That shows that you are a hopelessly inexpierienced, clueless, newbie who does not realize that things are never different.

A:  (Apologetic and hanging head) Oh… well it does seem different.

B:  Don’t you know that we all got buried in the bubble because we thought it was different?

And so forth.

Here on "A Dash" my intention is to show readers how to tell when things really are different and why this is important to know.

Some of my kind friends over the years have said that I have a knack for taking complex topics and making them clear to my audience.  I am probably better at doing this in public speaking, but I am going to attempt it here anyway.

My normal method, familiar to professors teaching research methods, is to take a blindingly clear example unrelated to the problem at hand.  With understanding of this in mind, one then tries to show the audience the similarity to the current problem.  If someone thinks that the examples or method are too obvious, then a pat on the back is in order.  Anyone who gets it already is way ahead of most consumers of stock market research and analysis.

Let’s start by getting rid of the dismissive nature of the "This time it’s different" putdown.  There is no advantage in following the slogans of everyone else.  If you are a sophisticated player in the market, it is your mission to discover when it really is different.  It is my mission to suggest places where that might be true.