How to Simplify the Way You Think About Money

One of the common refrains in behavioral economics and behavioral finance is that we, as humans, act irrationally and make a lot of mistakes. Of course, this is true to some extent, but are we really so bad? Are the mental shortcuts, or heuristics, that we use to make decisions all bad?

Gerd Gigerenzer, a research psychologist, says in an interview with Harvard Business Review that we need to stop thinking of shortcuts as negatives . In fact, he argues that heuristics can not only be rational, but incredibly powerful. The key is to develop the right instincts so that your shortcuts are more accurate.

The limitations of statistical models

In a place like finance, using "rational" statistical models won't always give the best solutions because estimating risk probabilities is actually really hard. Gigerenzer uses the example of "value at risk," a model that estimates the maximum probable loss on a portfolio. He says of the years leading up to the crisis:

In other words, while such models are very sophisticated from a mathematical point of view, they won't help you if something suddenly changes -- which, as we all know, happens all the time. In these cases, Gigerenzer argues that a simple heuristic could be much more powerful: perhaps implementing a maximum leverage ratio.

Why would this work? A simple rule means fewer variables to estimate and develop probabilities for, less wiggle room for banks to game the system, and no error terms to contend with. A classic example of an "irrational" heuristic beating out a complex and sophisticated model.

So instincts are good?

Gigerenzer refuses to buy into the dichotomy of "instinct" versus "reason," and for good reason. He points out that in any given situation, like our value-at-risk example, a heuristic might be more powerful than a "rational" decision-making scheme, and that heuristics applied rationally are no longer irrational.

Another great example is Harry Markowitz's portfolio allocation system. The name might ring a bell -- Markowitz invented modern portfolio theory, which stresses the maximization of returns for a given amount of risk by diversifying across low-correlation assets.

But when asked how he invested his own portfolio, Markowitz threw out his Nobel prize-winning framework and used a simple "1/N" heuristic -- in other words, for a given number of investment choices ( N ), he just divided his assets equally among them.

Sounds kind of stupid, right? But it turns out he was onto something -- according to Gigerenzer, these portfolios actually often outperform their modern portfolio theory counterparts.

What does it all mean?

It means that heuristics are not silly behavioral quirks when applied correctly.

The trick is to develop your instincts through education and experience. If you have a lot of trouble understanding what risk and uncertainty are, your heuristics might not be so sharp. On the other hand, if you have what Gigerenzer refers to as basic risk literacy, your heuristics are likely to be a lot stronger.

In other words, with some understanding of risk and uncertainty -- and taking that understanding beyond basic statistics, which relies on assumptions and some level of certainty -- we'll be better able to handle, and develop smart and simple rules of thumb for, the real-life complicated world.

And that would be pretty smart indeed.

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