Science News - June 4, 2011

traditional economists’ sophisticated decision models a run for their money, research suggests.

From investors vying for a financial edge, to business managers trying to target loyal customers, to high-powered entrepreneurs looking for profitable business locations, new studies celebrate the efficiency and power of mental shortcuts. In uncertain economic situations where time is precious and information incomplete (of which there are a lot these days), heuristics can quickly narrow down a bunch of choices to a few good bets, says economist Nathan Berg of the University of Texas at Dallas.

“The economic environment con-
stantly changes, and the whole menu of
choice options that economists tradi-
tionally study isn’t immediately visible,”
he asserts. “People can make better eco-
nomic decisions by using simple rules
of thumb to limit the number of choices
they consider.”
Many firms pay dearly for complex
investment packages that calculate
risks and benefits of an array of potential
assets based on each one’s previous per-
formance. Others devise secret invest-
ment formulas. “These approaches do
well at predicting the past,”
Gigerenzer says. “But they
have problems predicting
the future.”
In an economic world in
perpetual flux, elaborate
investment models that
explain a bevy of historical
trends can identify some
genuine moneymaking
opportunities but mistake
many accidental and random finan-
cial patterns for good bets, Gigerenzer
argues. By ignoring past financial infor-
mation, 1/N misses some profitable
buys but rebounds nicely by spreading
out investment risks without throwing
money at a lot of illusory prospects.

Gigerenzer was inspired by a 2009 study led by economists Victor DeMiguel of the London Business School and Lorenzo Garlappi of the University of

“People can
make better
economic
decisions by
using simple
rules of

NATHAN BERG

Texas at Austin. Using 40 years of data from the U.S. stock market, DeMiguel and Garlappi found that 1/N portfolios consisting of either 25 or 50 stocks usually generated greater returns than 14 complex models for investing in the same stocks.

Given a portfolio of the same 50 stocks, an investor would need to wait 500 years before Markowitz’s Nobel-winning formula yielded superior returns to 1/N, the researchers estimated.

Markowitz remains skeptical of the findings and plans to closely evaluate the team’s calculations.

Naïve diversification works well for large portfolios but often backfires when applied to a few assets, says Richard Thaler of the University of Chicago, a leading behavioral economist and critic of Gigerenzer’s approach. Financial disaster looms when people put equal amounts of their life savings into a handful of stocks, especially if those people invest in a company they work for, Thaler says. Think Enron or Bear Stearns.

Thaler, who advises a British govern-

Keep it simple

A major international insurance company found that lesson out the hard way. The head of the firm’s investment department attended a recent lecture about the power of distributing money evenly among assets, given by psychologist Gerd Gigerenzer, director of the Max Planck Institute for Human Development’s Center for Adaptive Behavior and Cognition in Berlin. Skeptical but intrigued, the insurance honcho returned home and reanalyzed his company’s investments from 1969 to 2009.

To his surprise, a 1/N portfolio would have made more money in that time than any of the complex strategies that his department had employed. Naïve diversification requires periodic reassessments of which stocks and other assets to include in a portfolio. Yet regardless of how the insurance official realigned the portfolio, 1/N came out ahead.

He told Gigerenzer about the results, asking that his identity and his company’s name be kept secret.

Quantity of information evaluated

Maximizing returns Dallas entrepreneurs choosing locations for a new business report that
they rarely do the exhaustive research that traditional economic theory calls for, instead relying on
rules of thumb. The event tree (below), which agrees well with interviews with 49 entrepreneurs,
shows bigger returns for investors who put in a little money and imitate others’ locations and for
those who put in a lot of money, locate away from others and consider few properties. SOURCE: N. BERG
High info
i