Five Commandments For Investors

19th Jun '14 by timarr

4 comments 11499 reads

One of the more thoughtful regulators around is Andrew Haldane of the Bank of England whose speech “ The Dog and the Frisbee ^[1]” from 2012 remains the touchstone for anyone wanting to appreciate the reasons that modern economics has made a mess out of understanding the real world. To boil the whole thing down to a single statement: you can’t control a complex system with complex rules, complex systems require simple rules.

Applied to regulation this is revolutionary, applied to investing it adds to reams of evidence suggesting that most investors need to avoid overcomplicating their analyses, that simple rules of thumb outperform detailed analysis and that mostly we’d be better off going off to the beach with a Frisbee rather than pouring over the latest numbers. It’s all guesswork anyway, best take the easy option.

Haldane’s point is that dogs don’t catch Frisbees by solving complex equations and adjusting for gravity, but they succeed in doing so anyway despite the fact that it’s a fiendishly difficult mathematical problem. In fact they use a simple heuristic:

“Run at a speed so that the angle of gaze to the Frisbee remains roughly constant. Humans follow an identical rule of thumb.”

If, instead, they – or we – were to try and solve the physics behind the problem we’d never catch the damn thing. But the point is, of course, that a dog can catch the Frisbee even though in mathematical modelling terms it appears next to impossible and no one believes that the hound is calculating anything very much. Everyone, that is, apart from economists and regulators who have been beating a determined path away from the idea that simple rules can produce good results where complex analysis all-too-often fails.

Although, to be honest, I doubt many economists believe that this is true any more. The trouble is that the discourse of economics, the idea of the rational, self-serving individual leading to the best allocation of capital is now endemic. It's spread beyond the confines of economics into every nook and cranny of the world, infiltrating thought patterns and infecting institutions: so any attempt to change this from within is more than welcome.

Haldane argues that most modern regulation has been about managing risk, following the two key economic models of decision making under risk – the…

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Mark Carter

19th Jun '14

Good post, timarr.

Of course, it's never going to happen, because imperatives dictate that people must make it complicated. I seem to recall Greenspan giving an interview with the BBC, in which he boasted that economics was complicated, and if you wanted something easier, try quantum mechanics. The sheer arrogance and conceit of the man!

Nassim Taleb also has much to say about complexity and the fragility of systems. Economists aim to eliminate and precisely quanitfy risk. Taleb argues that such things are doomed to failure. A shift in empahsis is required. Instead of trying to arrange the world so that things never go wrong - an impossibility - the trick is to construct systems that cope well when things go wrong.

I saw a YouTube video recently about the way Yahoo organises its data centres. As you can imagine, Yahoo has a lot of data to contend with. Formerly, it tried to make its data centres resilient to failure. To give an example, it installed UPS (Uninterrupted Power Supplies) (which are basically batteries and line conditioning circuits) to guarantee an uninterrupted supply of electricity to its computers. Counter-intuitively, the UPS created an additional point of failure, and actually accounted for around half of the power supply problems they had. In one centre, for example, the UPSs caught fire.

Now their approach is much more geared towards "failover". Instead of designing systems that never go wrong, Yahoo now arranges it so that if one centre goes down there is enough redundancy so that another centre picks up the load. It's pretty much seamless.

timarr

Hi Mark

All too true, unfortunately. Back in Roman times architects were made to stand underneath their structures when the final scaffolding was removed ... but I suspect that you're right; our financial systems are so complex they'll always fail so we shouldn't assume we can ever prevent the failures, and concentrate on how we mitigate the problems when they occur. But I think the rule with economists is the same as with every expert, distrust certainty, there is none. Unfortunately people generally prefer gurus who exhibit certainty, and then ignore their inevitable failures.

On the bright side, even a small understanding of these issues can give someone an investing edge :)

Tim

Edward Croft

Timarr - there's a great chapter in a James Montier's book about a study which shows that bookies don't make better decisions when they have more than about 5 data points. What happens as they are given more information is that the confidence in their predictions keeps rising, but the accuracy doesn't improve.

Personally, and I'm biased, that's the great merit in simple screening and ranking methods for the stock market. As long as you diversify reasonably and stick to good rules you'll do much better than second guessing yourself or diving vastly deeply into the intricacies of each stock you own.

An understanding of human nature and folly is so vital. Simplicity is vital, and Less is more.

Great article as ever !

Hi Ed, yeah there's quite a lot of stuff around about how more data doesn't improve prediction. In fact one study suggests that more data would allow us to make better stockmarket predictions than using a simple rule, but only if we had 500 years worth - for the same shares. I wrote about that recently in The Turkey Illusion. Simple heuristics very often work better than complex rules: but you still need to choose the right heuristics!

Tim

Five Commandments for Investors

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Timarr

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