The Replacement Heuristic

All day long we answer questions. Who should be the next president? Do you love me? What do you want for dinner? Are you tired? Should I buy that stock?

Our brains don’t just go and answer those questions straight up, they are too difficult and we as a species are naturally lazy. We don’t engage our deeper thinking systems as much as you might think we do, a vast majority of decisions we make, even┬áconsciously are made with system one, the fast reflex system of the brain that isn’t so taxing both mentally and physically (there is a very strong link between the two).

This allows us to answer a lot of questions, and we do a damn good job with most of them. It’s not necessary that we ponder deeply whether we should cross the street every time we come to an intersection. Our system 1 looks at the cross walk sign, easily makes a judgement as to whether it’s white or red, we might check for cars in either direction, and we walk, or not.

But when we’re asked a tough question, such as, who should be the next president, we often experience what’s called the replacement heuristic. Instead of slowing down and ┬ádeeply analyzing the question, because our brains are lazy we often replace the difficult question with easier ones.

Which of the candidates looks like he or she should be president?

Which candidate do I trust more?

Who is my (spouse, fried, parent….) voting for?

Many market participants also do this when deciding on what stocks to buy or sell. When they are posed with a tough question such as, which stock from my investable universe will perform best over my chosen time frame with the risk profile of my choice, a tough question to answer, they will replace it with:

Which stocks have I heard about in the news a lot recently?

What products have I had good experiences with recently?

What stock did that cab driver tell me to buy the other day?

Another way to explain the replacement heuristic is to ask someone to evaluate the investment potential of two stocks over a period of time. In many cases, the person will replace that question by asking which company he feels will perform best fundamentally, which executive team he likes best, which product he likes best, etc. In some cases this person will use these other questions to build a profile in his mind of what attributes contribute to the investment potential of a stock, but in many cases the individual will directly substitute the investment potential question for one of the above where the correlation between the two is very small. And at the end of the day, only price pays, those other characteristics do not.

We are lazy creatures and this is how our mind works. Breaking up big hard questions into other easier to answer questions is something we do naturally which can be both harmful and helpful depending on whether it is done in an engaged way or a passive way.

Advertisers will attempt to pray on the replacement heuristic whenever they can. Politicians will ask you, are you better off now than you were 4 years ago, as a replacement for, who will you vote for? Is there a strong correlation between whether you feel you are better off now than you were 4 years ago and whether or not you will actually be better of in the future than you are now? It’s possible, but not probable.

We can get around our lazy brains by using check lists and working in groups to help each other spot situations in which we are suffering from the replacement heuristic. I have found that when trading this is one of the most important things for me to do. I ask a simple set of questions each time I make a trade. It’s also much easier for others to spot when you are falling victim to the replacement heuristic, unfortunately we are somewhat trapped inside our own machinery. Great groups keep an eye out for each other.

So the next time someone asks you who should be the next President, try not to think of Romney’s beautiful hair, or Obama’s massive smile, they both have zero correlation to how successful they’ll be the next four years.

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