Saturday, May 9, 2015

Ecological Rationality - know your investment environment



Specific skills are needed for any environment faced. The wilderness guide will have a hard time figuring out Manhattan just like the Manhattan upper east side socialite will be truly lost in the Boundary Waters of Minnesota. You have to know the environment or terrain to successfully navigate yourself through some wilderness. Everyone get that simple premise. A classic comic device that we love is seeing someone juxtaposed into a strange environment.  However, we are not willing to accept this thinking when looking at decision frameworks.

The environment for making investment or trading decisions will be different from an environment where there is a a lot of time available to sort through information and choices. This has influenced the work by some the leading decision science researchers and we think it is key in determining how to make better investment decisions. We know that that decision-making can be either fast or slow and the choice is based on the type of problem faced.

Rational choice theory or the expected utility maximization can take a lot of time and effort, so there are reasons for making simpler decisions or employing simple heuristics. This is what systematic trading is all about. In a fast paced complex world, make simple choices. Buy what is going up and sell what is gong down. If you lose a certain amount of money, get out of your positions. If you have less information, use price as your guide. A long-term value investor by nature will take longer to make a decision and should not use simple rules. In the value decision, the weighting of all probabilities makes sense. If you need more information, stop and get it. Look for the details and not just the price action. The same applies to those investments which are illiquid. The cost of being wrong is high with an illiquid investment so the deacons should be slowed. For liquid investments, the environment is very different.

In a liquid fast paced market, the rules of decision-making will be rational but will be different than the rules of engagement of long-term investing. This is the foundation of ecological rationality.

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