Take a look at this baseball player. He's doing something extraordinary.
A ball was hit a few hundred feet away, coming off the bat at about 90 miles per hour. In less than five seconds the outfielder ran to the exact location the ball landed, down to the centimeter, catching it without a blink to spare.
This is extraordinary because of what he needed to figure out in those five seconds. He had to know the ball's initial velocity, spin, and angle. He had to know the exact speed and direction of the wind, since it would alter the ball's trajectory. He had to know 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:
This is nearly impossible to calculate in your head. Yet players do it all summer. According to Inside Edge, 84.7% 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 Lenny Dykstra did thousands of times.
Baseball 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 center of your gaze.
- 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.
Baseball players 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.
In a masterpiece investing speech, Dean Williams recalled the story of an investor who mastered simplicity. Thirty years ago, Pensions & Investment Age magazine made a list of 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). 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 baseball player 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.
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% a year after inflation over a multidecade 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.
Rebalance your mix of stocks and bonds every few years. Don't put any extra thought into it.
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 unpredictable times every 20 years.
Prefer companies that reward shareholders with consistent dividends and share buybacks. Trying to calculate whether a CEO 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 favor 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% of what you make, and as much as you can while still living comfortably.
You might think successful investors are brilliant minds who can calculate complicated things with precision. They rarely are. The best are more like baseball players, able to solve complicated problems by using simple rules of thumb. "Simplicity is a prerequisite of reliability," said Edsger Dijkstra. Try doing less.
Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.