I’ve been reading “Simple Heuristics that make us Smart” by G. Gigerenzer and P. Todd, since I found it referenced in an investment book.
The authors define the term “heuristic” as “serving to find out or to discover.” In the early 1900s, Einstein used the term as “an approach to a problem that is necessarily incomplete given the knowledge available, and hence unavoidably false, but which is useful nonetheless for guiding thinking in appropriate directions.”
With the advent of information processing theory in cognitive psychology, a heuristic came to mean a useful shortcut, an approximation, or a rule of thumb for guiding search, such as a strategy that a chess master uses to reduce the enormous space of possible moves at each point in a game.
Read that last paragraph again. Isn’t that what most investors are faced with when trying to make investment decisions? Reducing variables in the decision making process is what I like to call it. Here’s how the authors describe the simplification of a decision making process:
There is a sound reason why a person might base a decision on only one reason rather than on a combination of reasons: Combining information from different clues requires converting them into a common currency, a conversion that may be expensive if not actually impossible.
That is exactly what you are faced with when making investment decisions based on fundamental analysis which, given the wide variety of information available, may require you to have the anticipating mind of a chess master.
Even if you have the time and ability to correctly analyze hundreds of data points leading to your ultimate investment decision, and the purchase of a certain mutual fund or ETF, you will still need one more thing once you are actually invested. That one thing is a trend in place to propel your investment higher assuming you took a long position.
My take on using heuristics is that my trend tracking approach filters out all of the noise and reduces dozens or hundreds of variables to only one that I can measure: The trend; is it up, down or sideways?
It’s a far simpler and more effective process, one that I have used even before I knew what heuristics were all about. The book is only interesting to a certain point for me. It’s not an easy read, and I will most likely not finish it since it’s more suited to a psychologist or therapist in that field.
This not meant to be demeaning to the quality of the book; it’s just my shortcoming that my interest in that subject is limited.