Monday, November 16, 2015

Assuming horses not zebras is good decision-making



Intelligence is a form of diagnosis and medical students are taught, "When you hear hoofbeats, think horse, not zebra." In other words, the patient is likely to have a common disease, not an exotic one. 
- Robert Jervis Why Intelligence Fails: Lessons from the Iranian Revolution and Iraq War

The same logic should be applied to investment problems. Look for the obvious answer before developing more elaborate explanations. For example, if equity markets are going down around the world, look first at the simple explanation that there are expectations of a slowdown in growth. If nominal rates are declining, it is likely driven by falling inflation expectations and slower growth. Do not fight the Fed and liquidity. 

Of course the world is more complex than just simple explanations, but starting with the broad simple explanations is a good working hypothesis for discussion. If you have an alternative story it has to be framed in the context of how it compares with the common explanation.  Contradictory information has to be studied assuming the most likely answers as the prior. Start simple and add complexities and alternatives to a your investment theses. 

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