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Good Enough

By Morgan Housel - Jul 20, 2015 at 11:32AM

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Why rules of thumb beat precision.

NASA's New Horizons spacecraft passed by Pluto last week, which is amazing. It was a three-billion mile trip that took nine and half years.

But here's what blows my mind. According to NASA, the trip "took about one minute less than predicted when the craft was launched in January 2006."

That is astounding. In an untested, decade-long journey, NASA's travel forecast was 99.99998% accurate. It's the equivalent of forecasting a trip from New York to Boston and being accurate to within four millionths of a second. (Your move, Google Maps.)

This is a great reminder that some fields work with amazing precision. They are governed by pure math and physics, and aren't burdened by the whims of human emotion.

It's also a great reminder that investing is not one of these fields.

Investing is often taught as if it's something like aeronautical engineering. It's filled with precise equations that give exact answers in the way you would calculate, say, how long it takes to fly to Pluto. Seriously, look at this stuff

Traders calculate moving averages and support bands. Economists create forecasting models to tell us how much GDP will grow this year. Chief market strategists model what the S&P 500 will do in the next year. The bulk of academic finance is based on the idea that if we try hard enough and crunch enough numbers, we can grab capitalism by its horns and forecast what will happen next. And I shake my head at that idea.

Sometimes I say, "Well Morgan, maybe you just don't understand this stuff." Which is true! But the evidence is overwhelming that those who wield complicated investing math don't understand it, either. A novice would never think stocks falling is a once-in-a-billion-year event. You need a Goldman Sachs forecasting model to think that. A normal person would have a hard time losing everything during the booming late 1990s. You need a team of Nobel Prize winners to do that. Find me one person who has gotten rich investing with his mathematical chops and I will show you nine who blew themselves up, plus 20 bumpkins who became rich using simple rules of thumb.

There are two types of stupidity. One is simple ignorance. The other -- far more dangerous -- is brilliance so deep that you assume it applies to unrelated fields. At the center of every financial catastrophe is the latter; a genius whose forecast was mathematically unassailable right up to the moment of bankruptcy. It wasn't that their math was wrong. It was that their clean math didn't apply to the hormonal jungle of finance.

One of biggest investing lessons I've learned is that the more precise you try to calculate, the further from reality you're likely to end up. Precise calculations creates a spell of overconfidence, which makes you double down on whatever you want to believe no matter how wrong it is. Some examples are staggering: Wall Street's top market strategists predict each January how much the S&P 500 will go up over the following year. Their collective track records are worse than if you just assumed stocks go up by their long-term history average every year.

In a messy world of emotions and misinformation, broad rules of thumb can be an excellent strategy.

Rules of thumb aren't perfect, of course. But that's their advantage. By starting with a strategy you know isn't perfect, you naturally leave yourself room for error, and are more flexible in accepting the market's whims.

So I don't use fancy valuation models to calculate how much stocks should return over the next 10 years. I assume 6% a year after inflation over the long haul. I figure that's good enough.

I don't forecast what the market will do this year. I assume the market will go down half of all days, a third of all years, and a fifth of all decades. That's probably good enough.

I don't predict what the economy will do this year. I assume we'll have a recession every five to seven years. Good enough.

Don't bother me with calculators that show me how much money I'll have in 30 years. I don't know what my bills will be next month. I save as much money as I reasonably can while living a lifestyle that I'm content with. I figure that's good enough.

Spare me with your analysis of why I should own stocks from some country because of economic trends. I'm diversified, and accept part of my portfolio will always be doing worse than others. I figure that's good enough. 

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