Can This Simple Mathematical Rule Minimize Investing Regret?
I recently read a great book called “Algorithms to Live By” by Brian Christian and Tom Griffiths. It’s a fascinating look into how computer scientists have been devising solutions for life’s thorniest conundrums.
Some of the most interesting – and most difficult – problems ever solved dealt with what’s called “optimal stopping.” The answers help us figure out when to stop a search, be it for a romantic partner, an apartment, or even an investing strategy.
How Optimal Stopping Problems Work
Imagine you’re hiring for an open position at your company. You want to make sure you hire the best candidate possible without it consuming all your waking hours, but you also need to make sure you see enough options to be confident you’re making the best choice. By definition, the first applicant you see will be the best one so far — but that doesn’t mean you should hire him or her. There could be an even better candidate out there. But, how many people should you interview? Five? Ten? One hundred? When do you stop?
While it might be hard to imagine, there is a statistically correct answer. You should interview 37% of the available candidates, and then hire the next candidate who’s better than the rest you’ve seen. It’s counterintuitive, but the math backs it up (I won’t get into all the equations, but further reading on that front can be found here).
This answer is counterintuitive because it means that even when following the best possible strategy, you’re going to have a 63% failure rate. That is sobering. If you’re anything like me, you’re thinking that is simply unacceptable. Despite what those computer geeks say, I would just know when I saw the best person.
But, it’s been proven time and again that our intuitions are not up to the challenge. It’s a sobering realization, but an important one. We all only have so much time on this earth. We can’t spend it all trying to find “the one,” as much as we think we’d have perfect success if we were only able to see every possible candidate. That is simply an inefficient, risk-averse way to living life. We’d do better to look for a certain period of time, and then leap once we reach the 37% threshold.
How the 37% Rule Can be Applied to Investing
While learning about the 37% rule, I couldn’t help but see the parallels to investing. A perusal of personal finance message boards across the internet are filled with some version of the following question:
“I know I shouldn’t have all my money sitting in a low-interest savings account, but I just don’t know what to do with it. What investing option should I choose? There are so many options and I’m scared I’ll pick the wrong one. Help!!”
These people are suffering from “analysis paralysis,” which is the tendency to think and think and think until your brain is so jumbled that it’s easier to just do nothing and forget about the issue altogether.
Thankfully, when approaching this problem through the lens of a computer scientist, we are able to take the emotion out of it. If these people applied the 37% rule, they could ease their mental burden.
A simple way to do this would involve a bit of reading. First, they could go to the library and check out 10 of Wiley’s “Little Books” on investing. Each of these short books contain a different investing strategy.
The books will not address every contingency. But, they have one thing in common — they get your money out from under the mattress and into income-producing assets. They are also well-written and easy for the layperson to understand.
Start with something that catches your eye, and read it. It won’t take that long. The books are are all designed to be quick reads. When done with the first, move on to the next one that interests you. After the third book you’ll have both a better understanding of your options and broad knowledge of investing in general.
You are now 30% of the way through your search. That means the 4th book will push you over the 37% threshold. So, after the third book, you will officially transition from “look” mode to “leap” mode. There are seven books left in your stack. You should now implement the strategy from the next book that appeals to you. Maybe it will be the 4th, 5th or 6th. Maybe you make it all the way to the end, in which case, given the constraints of this experiment, you simply implement that strategy. Boom. Done.
That might seem scary, but again, this is not about finding the “best.” The best literally does not exist, except in hindsight. All this strategy does is get you to the “best yet,” which is all you can hope for.
There are people who will argue that, “Sure, it’s easy when dealing with hypotheticals, but this is my life savings we’re talking about here! I can’t just read a couple short books with that kind of money at stake.”
We nerds have empathy for that type of thinking. It’s trickier to apply the 37% rule to problems that have many variables and which are tremendously important. But, that doesn’t mean it’s impossible. You just have to do the best with the knowledge you have, which, surprisingly, is all that even the most advanced computer algorithms are doing.
Kind of like how the famous Dr. Strangelove “learned to stop worrying and love the bomb,” we must “learn to stop worrying and love the math.” If you’re behaving rationally and leveraging over 70 years of knowledge from some of the greatest mathematical minds of all time, what is there to regret? Nothing is ever perfect, and the perfect is the enemy of the good.
You Can Still Be Flexible
Optimal stopping doesn’t end with your choice of investing strategy. If you choose a path and your circumstances change, then by all means, change your approach. Depending on your age and risk tolerance, your new strategy can take many different forms. You might be excited by the high risk and high returns of a 100% stock portfolio, you might crave the security of investing in U.S. Treasurys, or maybe you want to use an established “robo-advisor” that will create and manage a set-it-and-forget-it portfolio for you. Low-cost target-date funds are another solid option for people who don’t like monitoring their finances.
But, as you try new things, the same optimal stopping formulas apply. If you’re quite experimental, and you have it in your head that there are 20 strategies you want to try, then pick the next strategy that fits your temperament after having tried seven options (as 37% of 20 is 7.4).
Changing investment strategies means incurring costs. The taxes and fees associated with switching things up will eat away at your investment returns. That’s why it’s common advice to pick something and then stay the course. If you’re applying optimal stopping principles, you should stay the course after you’ve considered 37% of a selected group of options.
Every day spent living in fear of the financial markets is a day you could be earning interest on your money. Sure, there are strategies in hindsight that could have earned you more money had you adopted them, but by definition you can’t know that in advance. All you can do is trust the process. The one surefire way to lose is to do nothing at all.
If you think about things as if you were solving a thorny computer science problem, you might be able to see that there is an optimal time to end any search. The 37% rule can help you both get started on your investing journey and let you know when it’s time to stop tinkering and enjoy the ride.