And irrationally following rules of thumb, or heuristics, is the cause of human errors, including financial disaster.
Sound rational decision-making, in contrast, follows the laws of logic and probability theory. The best strategy: calculate the option with the highest mathematical expectation and steer away from intuition or heuristics.
Modern portfolio theory is said to have started with Harry Markowitz, whose mean-variance portfolio is taught to every finance graduate. When Markowitz did his own investments for retirement, one would have expected him to use his Nobel Prize-winning optimisation method. In fact, Markowitz instead relied on a simple heuristic, known as 1/N (See Markowitz’s method, below).
Those who claim that calculation is always superior to heuristics also miss an important point made by Frank Knight almost a century ago. There is a huge difference between situations of risk and situations of uncertainty. In a world of risk, all alternatives, consequences and probabilities are known, or can be reliably estimated. In a world of uncertainty, that is not the case.
Does this mean that the Nobel Prize-winning method is a sham? No. Markowitz’s mean-variance portfolio is optimal in a world of risk, as defined by his assumptions, but not necessarily in the uncertain world of the stock market, where so much is unknown. To use such a formula requires us to estimate a large number of parameters based on past data. Yet, as we have seen, 10 years is too short a time to get reliable estimates. Say you invested in 50 funds. How many years of stock data would be needed before the mean-variance method beats 1/N? A computer simulation provides the answer: about 500 years. That is, in the year 2500, investors can stop using the simple rule and do the calculations, provided the same stocks and the stock market itself are still around.
Some time ago, I gave a keynote at the Morningstar Investment Conference, explaining in some detail when and why simple rules have an advantage over complex strategies: if the situation is fairly unstable and unpredictable, if the number N of assets is fairly large and only small amounts of data (such as for 10 years) are available. In the audience was the head of investment of a large international insurance company, who afterwards came up to me and said he would check his company’s investments.
A few weeks later, he told me that he had checked the investments since 1969: “I compared 1/N to our actual investment strategies. We could have made more money if we had used this simple rule of thumb.” Then the real issue came up: “How do I explain this to my customers? They might say, I can do that myself.”
But customers still face plenty of open questions that professionals can help them with: how large N should be, what kind of stocks, when and how often to rebalance. And, most importantly, exactly when and where 1/N is a successful strategy.