Monday, December 28, 2015

Simple Rules - Arguing for less complexity in money management

Remember the KISS method for modeling and decision-making? Keep It Simple, Stupid! The quick and easy read, Simple Rules - How to Thrive in a Complex World by  Donald Sull and Kathleen Eisenhardt, two leading management gurus, more fully develops this key concept. Their premise for good strategy and management is to celebrate simplicity through the use of rules that can be easily implemented and remembered. When there is a lot of uncertainty, making your decision more simple is better than trying to develop more complex processes to find a solution. Rules of thumb are useful when there is a high degree of uncertainty from a shortage of information and time.  When you think about the degree of uncertainty and complexity with investment decisions, it seems natural that a rules-based system should be considered and provide support to money managers.

Simple rules work because they do three things well. First, the set of guidelines are limited to just a handful of decisions. There is not a lot of decisions that have to be made, so actions can be taken quickly. Second, good simple rules are tailored to specific situations. There is not an attempt to generalize for all tasks. For money management, the rules are specific to money management. Third, simple rules try to eliminate bottlenecks in a decision process so there is not over-analysis. This is why they will be effective when there limited time. You avoid over-thinking a specific decision. They provide guidance but do not have to be overly prescriptive. 

Rules have structure and can be categorized. There are boundary rules which help limit the scope of the problem or decision. For example, the trend-follower will only look at price trends. This rule simplifies how decisions will be made through setting  boundary of what will be looked at. A second category is prioritizing rules or ranking. In the case of the trend-follower, it could be the criteria for determining a good trend. The third set of rules deal with stopping. In our example, it will answer the question of when should you get out of a trend or stop the process. The final set of rules is coordination or how rules tell others how to work together. For the trend-follower, this could be the process of setting a portfolio or coordinating the activities of multiple trends.

Make is simple. Keep it simple. But adapt when necessary. This is a good framework for anyone who is faced with a complex problem.

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