Best rule of thumb: Keep it simple

Simple maths? With all the complex factors influencing stock markets, it’s best to follow your intuition and some simple rules. Photo: Motley FoolTake a look at a baseball player or cricketer getting ready to take a catch in the deep. They’re doing something extraordinary.
Shanghai night field

A ball was hit maybe 50 or 80 metres away, coming off the bat at 140 kilometres per hour. In only a few seconds the outfielder ran to the exact location the ball landed, down to the centimetre, catching it without a moment to spare.

This is extraordinary because of what he or she needed to figure out in those few seconds: The ball’s initial velocity, spin, and angle. The exact speed and direction of the wind, since it would alter the ball’s trajectory. Exactly when the ball would switch from vertical ascent, lose speed, stall for a moment, and begin its decent.

The calculation necessary to know where a ball will land is a monster – just look at our graphic.

This is nearly impossible to calculate in your head. Yet players do it all summer. According to Inside Edge, 84.7 per cent of baseballs that hang in the air for five seconds end in an out. Stephen Hawking could not calculate this equation in five seconds, but cricketers do it thousands of times. How?

A rule of thumb

Players don’t actually do this calculation in their heads, of course. In his book Risk Savvy, Gerd Gigerenzer writes that, whether they know it or not, players use a rule of thumb to know where a ball will land:

Align a flying ball in the centre of your gaze.

Run.

Adjust the speed and direction of your run so the angle of the ball stays at the same spot in your gaze.

That’s it. As long as the ball’s angle remains constant in your gaze, you’re running to where it’s going to land. All the complicated math is captured in that rule of thumb.

Sportspeople intuitively understand something more investors should: complicated problems can be tamed with simple rules of thumb. And the more complicated a problem is, the lower the odds you’ll calculate it with precision, making rules of thumb indispensable.

Keep it simple

Thirty years ago, Pensions & Investment Age magazine made a list of US money managers with the best 10-year returns. Few had ever heard of the winner, Edgerton Welch of Citizens Bank and Trust, so a Forbes reporter paid him a visit. Welch said he had never heard of Benjamin Graham and had no idea what modern portfolio theory was. Asked his secret, Welch pulled out a copy of a Value Line newsletter and told the reporter he bought all the stocks ranked “1” (the cheapest). The rest of his day was leisurely. His only secret was taming a complicated problem — which stocks should I own? — into an effective rule of thumb: the cheap ones.

Investors should use more of this kind of thinking. Markets are endlessly complicated, investors are endlessly emotional, and there are no points awarded for difficulty. Overthinking things like valuation and modern portfolio theory can be the equivalent of a cricketer pulling out a calculator after each ball is hit, desperately trying to track its landing point with precision. Any time you can tame a complicated system into a simple rule of thumb, you will be better off.

A list of Don’ts

Don’t try to calculate when you should buy stocks. It’s too complicated a problem with too many unknown variables. Instead, dollar-cost average, buying the same amount of stocks every month or every quarter, rain or shine. Over time you will beat almost everyone who doesn’t follow this approach.

Don’t try to calculate what the market might return over the next year or two. You’ll never figure it out. Instead, assume it’ll return 6 to 7 per cent a year after inflation over a multi-decade period (with a lot of volatility in between), because that’s what it has done in the past.

If you do try to predict shorter-term returns, use the rule of thumb that the worse the market has done over the last 10 years, the better it will do over the next 10 years, and vice versa. Over time this rule of thumb will humble nearly every Wall Street strategist.

Don’t try to predict when we’ll have another recession. No one can. Instead, use a rule of thumb that we’ll have three or four recessions at random times every 20 years.

Prefer companies that reward shareholders with consistent dividends and share buybacks. Trying to calculate whether a chief executive is effectively reinvesting profits in his or her own company is hard, and evidence is persuasive that most are bad at it. Cash handed to you directly is more likely to accrue in your favour over time.

Don’t try to calculate exactly how much money you’ll need to retire. You have no idea what the future holds. Instead, save at least 10 per cent of what you make, and as much as you can while still living comfortably.

Foolish takeaway

You might think successful investors are brilliant minds who can calculate complicated things with precision. They rarely are. The best are more like cricketers or baseball players, able to solve complicated problems by using simple rules of thumb. “Simplicity is a prerequisite of reliability,” said famed computer scientist Edsger Dijkstra. Try doing less.

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