Market Commentary that addresses heuristics:
…We often get the recurring question: why is your method successful? This is especially the case when there is so much fundamental information available to use in making decisions. We think that our success has been based on simplicity; nevertheless, there often is a bias by some investors away from the simple manager in favor of those who discuss and try to account for the complexity of markets. To some, simple means unsophisticated; but there is a growing body of research work which suggests that simple methods of decision-making actually outperform their more complex alternatives. This certainly may seem counter-intuitive; but in a complex world where decisions have to be made with limited information and face real world time constraints, there may not be the ability to optimize over all possible alternatives. Under the real life situations faced by a trading firm, there is a premium on “fast and frugal” decision-making or heuristics. Fast decision-making is often based on just a few cues or inputs that may seem relevant. There is actually value in not using too much information. Researchers have found through testing that simple decision rules often can perform as well or better than more sophisticated forms of decision-making – especially when there is a high degree of uncertainty… There is a constant barrage of information; but often this information can be conflicting and, in some cases, does not come out with the frequency that we would like. For example, monetary policy can serve as a simple case. There are only a limited number of Fed meetings a year; however, this is supposed to help us infer the direction of interest rates and help us manage risk on a daily basis. How do you manage risk in markets that move 24 hours a day, when the fundamental inputs do not come frequently? In the grain markets, crop reports are fairly limited, and demand information comes with significant lags, if at all. How can this information be best incorporated in the daily price action? Under these types of conditions, simple approaches, such as following prices, may be better. In reality, our desire for effective decision-making is based on a simpler cue. Is the market going up or down? Has each position lost a predetermined amount of capital on a trade? We do not worry about trying to decipher all of the particulars of the market when action is required. In that case, the trend may be more than sufficient as a cue of what to do. It may actually be preferred to other information. Something to think about the next time you listen to a manager talking about the complexity of his thought processes as the indicator of his expertise as a manager. Signals are built into the market price…
The research finding that simple decision rules outperform complex ones under uncertainty is not new and not limited to trading. The same result has been documented in medical diagnosis, weather forecasting, and personnel selection. In every domain where decisions must be made with incomplete information and time pressure, the performance gap between simple rules and sophisticated models narrows and often reverses. The complex model overfits the data it was built on and fails on new data. The simple rule captures the core signal and ignores the noise that derails the complex model.
The monetary policy example in the commentary is precise. Fed meetings occur eight times a year. Markets move every second of every trading day. A fundamental approach that uses Fed policy as a primary input for daily risk management has a data frequency problem that no amount of analytical sophistication can solve. Price has no such problem. It updates continuously and reflects the aggregate judgment of every participant in the market about what Fed policy, crop reports, demand data, and every other input means for current value. The two questions the commentary identifies, is the market going up or down, and has each position lost a predetermined amount, are sufficient. They are not simplifications of a more complex truth. They are the signal. The complexity is noise.
The closing observation is the most useful: “Something to think about the next time you listen to a manager talking about the complexity of his thought processes as the indicator of his expertise.” Complexity in the presentation of a strategy is frequently a proxy for the absence of genuine edge. A manager who can explain clearly what they do and why it works does not need complexity to fill the explanation. A manager who cannot produce clear answers covers the gap with sophisticated-sounding language. The two-question heuristic the commentary describes produces no impressive presentation material. It produces results.
Frequently Asked Questions
What is a heuristic and why does it apply to trading?
A heuristic is a simple decision rule that uses a limited number of cues to produce a fast and reliable judgment under uncertainty. Research has shown that in complex, uncertain environments with incomplete information, simple heuristics often match or outperform sophisticated analytical models. Trading under real market conditions is exactly such an environment, which is why trend following’s two core questions, is price going up or down, and has the position hit its predefined loss limit, can outperform approaches built on far more inputs.
Why does using too much information hurt trading decisions?
Because in a complex, uncertain environment, additional information often adds noise rather than signal. Conflicting fundamental data, infrequent reporting, and the impossibility of optimizing over all alternatives under real-time pressure mean that more inputs produce more opportunity for error, not better decisions. The trader who uses price as the primary cue is using the input that reflects everything else already. Additional fundamental inputs add complexity without adding edge.
Why is complexity in a manager’s presentation a warning sign rather than a credential?
Because genuine edge in trading is expressible in simple terms. A manager whose process produces results can explain what they do and why. A manager who describes elaborate complexity as evidence of expertise is often covering the absence of a clear, testable process. The heuristic approach described in this commentary produces no impressive presentation. It produces the two questions that matter and the discipline to answer them systematically every day.
Trend Following Systems
Want to learn more and start trading trend following systems? Start here.
