Why Intuition Can be Better Than Analysis

There is an investing Rule of Thumb formerly used by prominent strategists called “The Law of 20″ (sometimes 22) that assumed over time that the combined market PE ratio and primary interest rate would return to a sum of 20. The Fed having put its foot on the neck of rates since 2008, any investor depending too heavily on this rule is out of business. VaR was viewed as gospel in terms of measuring credit risk after being tested by brilliant minds with exponentially more grounding in statistics and applied math than I have. Energy traders, as recently as the early 2000s, made huge bets based on US gasoline consumption until Chinese imports became the dominant determinant of oil prices. The rule in each case is that things change, and  the practice of reducing market strategy to individual indicators or relationships is, no matter how well back tested, subject to a likely-painful best-before date.

The impetus for these thoughts is a recent post by economist Nick Rowe emphasizing the non-linearity of economic forecasting, a thought which I am extending to asset markets. Rowe writes (read the whole thing though):

students really really wanted a linear story of the monetary transmission mechanism. And when I gave them a linear story they thought they understood it. They didn’t. They misunderstood it. They misunderstood it just as badly as a student who thinks “an increase in supply causes a decrease in price causes an increase in demand causes an increase in quantity” misunderstands demand and supply.

My students were like the people from the concrete steppes. The people from the concrete steppes want a linear story of the monetary policy transmission mechanism. Sorry, but you can’t have it. If you think you understand monetary policy through a linear story, you don’t understand it. The true story is non-linear. There is simultaneous causation, so endogenous variables are co-determined in equilibrium. Expectations matter, so the story has flashforwards and flashbacks, where the future affects the present. Those expectations are self-referential, because the characters in the story know the author who works at the central bank, and can anticipate the future plot he plans to write, which affects their actions today. That means a loosening of monetary policy could mean that interest rates rise, not fall. You cannot reason from an interest rate change (Scott Sumner), because interest rates are endogenous variables.

What professor Rowe is suggesting is that every relationship is subject to its context and that reductive analysis into tidy equations, while psychologically satisfying, often results in a weaker understanding of economic conditions. Deeper understanding, according to this theory, is derived using holistic, “whole picture” thinking. Easy to say, but what does this actually mean?

A practitioner of scientific, Rationalist thought will, when faced with a complicated system, immediately begin dissecting and organizing into component parts and this process encompasses the majority of market and economic research. Balance sheets are “broken down”, multi-trillion economies are encompassed by five letters, C+I+G +(X-M). A holistic view would have no real starting point beyond observing the entire system as it functions, which doesn’t seem like productive work at all, certainly nothing worth paying someone who isn’t Jane Goodall for.

As it turns out, however, our brains are doing a ton of calculations and analysis that it doesn’t bother telling us about, as neuroscientist David Eagleman describes in his book Incognito (a Kedrosky suggestion I’m currently reading, slowly).The author’s general view is that our conscious minds, far from running the show, don’t have security clearance for much of what our brain does. The depiction of vision was particularly fascinating. Researchers initially could not figure out why the process of walking down the street used up so much brainpower, in particular the areas associated with memory. Experiments uncovered that the conscious mind was barely functioning during mundane visual tasks, what was actually occurring was that our subconscious was busily comparing visual stimulus to expectations (born of memory) and only alerting our conscious selves when something surprising happened. This explains the “zoned out” feeling during long drives where time seems to have disappeared – our conscious brains were shut down because our subconscious didn’t see anything worth alerting us about.

Taken together, professor Rowe’s post and Eagleman’s research have fascinating potential implications for investors. Situations where the intuition of an experienced trader, drawing on subconscious calculations based on memory that we usually term “intuition”, could trump the data-driven analysis of an Ivy League economics professor are easily envisioned.

This is a blog post and I am over-simplifying. Intuition alone will never be sufficient for investing success. Professor Rowe’s thoughts, for example, are the outgrowth of decades of rational calculation and entirely conscious “Thinking Slow” (in Kahneman terms) effort, underscoring the idiocy of suggesting disbanding the rigorous study of economics departments in favor of everyone just trading and “feeling their way around”.  The financial crisis did, however, uncover embarrassing weaknesses in previously-revered methods of financial modeling and economic forecasting. The pervasiveness of this failure casts understandable doubt on the entire reductionist process by which the theories were derived, leaving both room for new methods of thought and a new respect for the intuition of traders.

 

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8 thoughts on “Why Intuition Can be Better Than Analysis

  1. jonas says:

    +1. A lot of the problems of the last 10 years is caused by the deprecation of intuition vs. mechanical linear thinking.

    Question for you: if you had to start with one book in this area, which would you start with first? Kahnemans or Incognito?

  2. kris says:

    I was wildly after this topic about 1.5-2 years ago. Couldn’t find an explanation until I saw Michael Mauboussin giving an interview to Steve Forbes. He’s got the answer. It’s all about luck.
    Future CANNOT be predicted, unless one is Prophet (we haven’t seen any of these it’s been few hundreds of years). As Taleb has explained, Prediction = Prophesy.

    Conclusion: Religious people call it: Gift of God. Irreligious people call it ‘luck’. Warren Buffet (irreligious) and Seth Klarman (religious) have publicly stated that ‘they are wired to be great investors’.
    This topic is closed for me.

    • kris says:

      To put it more bluntly:
      Warren Buffett having NATURAL (or God given) Investing Skills and putting them to use is no different from Michael Jordan having basketball NATURAL (or God given) basketball skills and putting them to use).
      It is as simple as this.

      • Bullshit! Buffett made his fortune by following the Graham-Dodd principles of value investing. He made so much money that way that he was able to buy entire businesses and manage them. He wasn’t a “natural” – he *learned* how to do what he did and got big enough that he couldn’t lose unless he was stupid.

      • kris says:

        http://www.evancarmichael.com/Famous-Entrepreneurs/635/summary.php

        Sir, thx for the comment.
        Too bad Mr Buffett disagrees with you. He deserves credit though for choosing to put into use that talent.
        “I was wired at birth to allocate capital and lucky enough to have people around me early on – my parents and teachers and Susie [his late wife] – who helped me make the most of it,” said Buffett.
        “Wired at birth” and “lucky”. Does it ring a bell?

  3. [...] Over time, most forms of analysis and measurement lose their inherent veracity.  (Interloper) [...]

  4. [...] Why Intuition Can be Better Than Analysis I think the situation is even more skewed. In markets it’s not just random change that destroys rule-based systems, it’s often deliberate competitive action to take away an edge. [...]

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