Heuristics... a necessary dependency

Heuristics are the rules-of-thumb we use to reduce life’s myriad complexities to manageable choices. Life without heuristics would simply be overwhelming. From the most basic tasks we perform to the most demanding decisions we make we depend upon heuristics to help us manage information, sort options and select preferences.

Consider hitting a golf ball. From the start of a back-swing to follow-through, hundreds of decisions and muscle movements are implemented. From the tips of your fingers to the tips of your toes small and large adjustments are made throughout the second or so it takes to execute a swing. Not only are many of these actions happening simultaneously, but often they are being reversed as quickly as they happen (e.g. shifting weight from foot to foot). To manage this through conscious decisions is beyond our ability. The level of complexity is simply too great for our relatively slow, plodding conscious mind.

Instead, our brain stores the golf swing in the unconscious as a series of heuristics. When it is needed, our brain fires off these heuristics in a highly choreographed sequence of smooth, flowing actions. In sports we refer to our capacity to perform a function without really thinking about it as muscle memory. In non-sports situations this ability is termed a skill or engrained behavior. The important point is that most of what is needed to accomplish the task at hand happens without conscious involvement – driven by a sequence of unconsciously triggered heuristics.

Heuristics can be observed throughout institutional investing. The time-honored "stop loss" is a prime example of a heuristic. Heuristics develop both intentionally and unintentionally. For instance studies show that manager’s often state emphatically that volatility plays no part in their investment decisions. Yet a rigorous analysis of their portfolio may find that there is indeed a persistent tendency where dramatic price movement changes the way the manager sells or buys positions.

Just like much of what we think and do is unconsciously driven, a great deal of what we learn is learned unconsciously. For example, if a portfolio takes a substantial loss and the senior fund manager bangs on the conference table and shouts, "We'll never again hold onto a Tech stock in which we have an unrealized gain and its price starts to jump like a kangaroo," well the chances are very good that some impressionable person in the room just formulated a new heuristic without even knowing it. The only way to understand all the heuristics influencing your decisions, and what impact they are having, is through rigorous analysis.