Do Rules of Thumb Apply to Investing?

“In an uncertain world, statistical thinking and risk communication alone are not sufficient. Good rules of thumb are essential for good decisions.” So says Gerd Gigerenzer in his book Risk Savvy: How to Make Good Decisions. Gigerenzer asserts that most of us misunderstand statistics and often don’t effectively use the information we gather to make solid decisions. And he insists we can all learn to make better decisions in the face of uncertainty.

The key? Rules of thumb, or as they are more formally referred to, heuristics.

In his book, Gigerenzer offers powerful examples of heuristics in action — among them, when US Airways Flight 1549 piloted by Captain Chesley Sullenberger ran into a flock of geese and landed on the Hudson River after he determined the plane would not make it back to LaGuardia. While you might expect that the captain measured speed, wind, altitude, and distance to decide where to land, he used a simple rule of thumb: Fix your gaze on the tower: If the tower rises in your windshield, you won’t make it.

Rather than waste time estimating the trajectory of the gliding plane, the captain relied on a rule of thumb. As his copilot Jeffrey Skiles explained, “It’s not so much a mathematical calculation as visual, in that when you are flying in an airplane, a point that you can’t reach will actually rise in your windshield. A point that you are going to overfly will descend in your windshield.” LaGuardia rose, so they landed on the Hudson — and everyone survived.

Gigerenzer insists that while rational thinking works well when assessing risks, often a combination of rational and heuristic thinking lead to better decisions under uncertainty. Rather than become overwhelmed with information, heuristics allow us to focus on a few pieces of information and ignore the rest. Of course, we have to ensure we are focusing on the right information!

There are a few investing rules of thumb I can think of that can expedite your decision making. For example, the Rule of 72 says that your money will double based on the annual rate of return that you earn divided into seventy-two. So, if your mutual fund earns 8% annually, you can expect that your money in the fund will double every nine years (72 divided by 8). You can employ this rule of thumb to quickly figure your opportunity cost for various investments. That is, should you invest in rental real estate that generally doubles in value every twenty years or keep the money invested in your investment account that’s earning 7%?

Using rules of thumb to guide your analysis may be helpful, but remember they are just step one in managing your portfolio.

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