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Rules of thumb challenge complex financial analyses

T

twilyth

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If you are an entrepreneur or even an individual investor and you have to decide were to put your money so you have the smallest risk of loss balanced against the best chance for a good profit, what do you do?

For decades, the answer from the ivory tower business schools has been to apply complex mathematics to mountains of data and wait for the computer to spit out the answer. But study after study has shown that money managers who use such strategies to beat the market almost never do over any significant time horizon. Some willl of course, just like there is the chance that I will be dealt 5 or 10 black jack hands in a row that total 21. Once in a while it happens, but as they say in the music business, don't quit your day job.

Now there is evidence that the whole idea of exhaustively analyzing an economic choice by considering every permutation of every possible choice might be fundamentally flawed.

It turns out that the people who actually go out and invest their money and are successful, don't do any of that. They instead focus on just a handful of criteria and a handful of options, often selected at random, and make their decisions that way. In fact, CEO's have been known to go to their technical people to have them come up with a mathematical justification for what amounts to a gut decision.

The may seem like common sense to most, but to any economist or MBA, it's just the opposite. Here's one short excerpt from the article.

Gigerenzer and a colleague, Nobel laureate economist Reinhard Selten of the University of Bonn in Germany, took that sacrilegious argument to a high cathedral of financial orthodoxy last year. The two were invited to speak, along with a pair of business entrepreneurs, at a prestigious annual gathering of the economics and business departments at Germany’s Bielefeld University.

Gigerenzer and Selten bluntly told the assembled professors and marketing researchers to scrap their curriculum. Trash their textbooks, too. Start teaching about how people in the real world make successful, profitable decisions based on informed shortcuts, without having to consult mathematical formulas dropped out of ivory towers.

“You should have seen their faces,” Gigerenzer says.

Although the audience reacted as if a couple of drunken longshoremen had crashed a faculty mixer, the entrepreneurs invited to speak at the event defended Gigerenzer and Selten’s heresy. Everything the two businessmen learned as MBA students was of no use to them, they insisted. Each had amassed a fortune by trusting gut decisions that often worked but were difficult to explain.

At other lectures on investment heuristics, heads of large firms have told Gigerenzer the same thing. Often, he says, masters of the business universe sheepishly acknowledge having hired a staff member to generate complex mathematical covers for their heuristic-based choices, so that clients and investors wouldn’t worry.

Equally troubling, Gigerenzer adds, is a tendency for complex forecasting formulas to encourage corporate complacency. Many businesses aim to predict financial crises with these tools rather than prepare to react flexibly to the next unforeseeable calamity, he says.

The article is about 4 pages and as long as you don't get bogged down in some of the details, it's pretty interesting.
 
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It turns out that the people who actually go out and invest their money and are successful, don't do any of that. They instead focus on just a handful of criteria and a handful of options, often selected at random, and make their decisions that way. In fact, CEO's have been known to go to their technical people to have them come up with a mathematical justification for what amounts to a gut decision.

The wife's fictitious portfolio she set up earlier this year is up 250%. Nine out of the 10 companies she picked, based on a handful of criteria, were gainers.

Wish I had some real money to invest :)

Edit: Whoops, meant 150% (1000 -> 2500)
 
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twilyth

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The wife's fictitious portfolio she set up earlier this year is up 250%. Nine out of the 10 companies she picked, based on a handful of criteria, were gainers.

Wish I had some real money to invest :)

Well, considering that we are flat to lower on the year, that's pretty good. The problem comes when there's real money the line. Even so, and even for a paper trading account, beating the market is no mean feat.

edit: hey, off topic, but what's with the mustaches on avatars? I'm trying to decide if I like the new look. Of course since I'm covered in fur growing a 'stache would be pointless, but I'm still curious. I'm thinking V for Vendetta?
 
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Good timing. I just watched V for probably the 10th time only a couple days ago. Was the first time my wife has seen it.

As for the mustache, I donned it awhile back when Chicken Patty was offering to Crunch under someone else's name. At the time I had 20+ machines Crunching for me, so I didn't really need the help and had to go incognito ;)

http://www.techpowerup.com/forums/showthread.php?p=1676718
 
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