Simple rules for smart investing
Gerd Gigerenzer and Andreas Ortmann
There is a wide-spread belief that it takes experts, or as they like to call themselves, "pros," to make smart investment decisions. This conviction is repeated endlessly by fund managers, professional advisers, journalists, and other self-appointed gurus of financial markets. However, the belief is a myth that contradicts the available evidence. We first review this evidence in language accessible to lay people and show that most of the strategies advocated by "pros" perform worse than standard benchmarks. Building on well-established results from economics, finance, and psychology, we then propose fast and frugal rules for investing in stocks. The strategies that we propose have a proven track record of performing well and, more often than not, they outperform the majority of "pros." Even when uncertainty and unpredictability is high, as is increasingly the case in stock markets, simple rules turn out to be robust. Frugal as they are, these rules do indeed make investors smart.
Key features of the proposed book:
1. We present time-tested simple rules for successfully investing in stock markets.
2. We build on well-established results from economics, finance, and psychology.
3. We contradict much of the current wisdom disseminated by "pros."
4. The book is written in language accessible to laypeople.
5. The book will be short.
The book targets laypeople interested in investing and financial market professionals. Preliminary reports about our research on smart and simple investment strategies has been featured in the U.S., Great Britain, Germany, and Austria, in publications such as The Wall Street Journal, Bloomberg Personal Finance, Institutional Investor Magazine, New Scientist, Science News, Der Spiegel, Focus, and dozens of newspaper articles and radio and TV shows.
Length and availability:
The manuscript will have approximately 30,000 words resulting in a book of about 120 pages. The complete text will be available by September, 2001.
Outline of the book
0. Setting the stage: Can a simple heuristic beat the editor-in-chief of a leading financial market magazine in a stock-picking contest ? If so, why?
1. The basics: A sketch of financial markets and instruments
The first chapter introduces the minimal knowledge needed to understand the way stock markets work.
2. Five key facts about stock markets
This chapter will summarize key evidence from the modern economics, finance, and psychology literature (e.g., Malkiel 1973, 1996, 2000; Carhart 1997; Barber & Odean 1999a, 1999b; Odean 1998a, 1998b, 1999; Borges, Gigerenzer, Goldstein, & Ortmann, 1999; Ortmann & Gigerenzer, 2000).
3. What explains the dismal performance of "pros?"
This chapter suggests why fund managers, professional advisers, journalists, and other self-appointed gurus offer, on average, advice that is bad for their clients, and why they seem to get away with it.
4. Five smart and simple rules for investing
(A bit of ignorance can be a smart thing!)
This chapter proposes a simple set of investment rules that turns out to be surprisingly effective. For instance, the "recognition heuristic," which underlies the first rule, exploits the wisdom of name recognition, which in turn underlies consumer choice. We report studies that illustrate the power of name recognition in financial markets. We offer an explanation for why these smart and simple rules work.
5. Arguments and counter-arguments
It is not surprising that financial advisors have argued adamantly against the efficacy of the simple rules we propose. Here we gather and refute the major arguments routinely made against the rationality of simple heuristics. This final chapter is structured as a "test" for readers, giving them an opportunity to put the insights from this book into practice.
About the authors:
Dr. Gerd Gigerenzer is director of the Center for Adaptive Behavior and Cognition at the Max Planck Institute for Human Development, Berlin, Germany. Formerly professor of psychology at the University of Chicago and other institutions, he has published numerous books and won many prizes, including the 1987 prize for the best PSP book in Social and Behavioral Sciences and the AAAS Prize for Behavioral Science Research in 1991.
Dr. Andreas Ortmann is assistant professor at the Center of Economic Research and Graduate Education of Charles University and research scholar at the Economics Institute of the Academy of Sciences of the Czech Republic in Prague. He has taught industrial organization, corporate finance, the economics of financial markets, and investment theory at Texas A&M University, Bowdoin College, and Colby College.