December 31, 2005

This time it really was different

A couple of weeks ago I was driving around town through a familiar intersection.  Having lived in for fifteen years in  Naperville, a kid-friendly Chicago burb of about 140,000 people, I have driven through this intersection thousands of times.  The light was green, a simple indicator that I could proceed.  On this particular occasion, however, someone was blasting through the intersection, against the light, at a high rate of speed.  As a cautious old guy I have learned not to depend on the simple heuristic of the green light.  The younger Jeff (and a lot of cell-phone gabbing teenagers in my neighborhood) might have had a serious accident.  But since I understood the underlying mechanism of the traffic signal I know that it is only an indicator of probable safety.

Earlier this month I heard the DuPage County sirens go off, indicating a tornado or disaster of some sort.  This is an important warning system, since there have been major tornado disasters a few miles from my home.  We take the warning seriously.  I glanced at the clock and noticed that it was 10:00 AM on the first Tuesday of the month, and remembered that this was the normal monthly siren-testing time.  By understanding the underlying mechanism, I realized that the indicator did not have its normal message.  (Some day there will be a tornado or disaster at exactly that time, but that is another problem).

The point for stock market observers is that there is danger in blindly following heuristics.  By paying attention to the underlying mechanism, called a causal model in social science research, one can avoid mistakes.

I understand that many of my readers behave just as I do in many real-life situations.  The question is whether they take that experience and apply it when they have a question related to the market.  I will provide examples where many Wall Street types show blind adherence to simplistic rules.  In fact, the example occur daily on CNBC faster than I can record them!

Please note the point.  I am not saying that those following the "rule" are wrong.  I am saying that without knowing the causal model, they do not know whether they are wise or blind.