Why do we resist rules of thumb and checklists?

You may be thinking: if they are so great, how come so few persons seem to use them. Actually, many persons (including many financial advisers) do use them, but it is true many persons do not. Here is the best explanation we could find:

Checklists are considered demeaning to our perception of the great complexity of our work: we believe our jobs are too complicated to be reduced to a checklist. Gawande, p.35

Checklists are also considered demeaning to our profound sense of self. Gawande, in his book, focuses specifically on their use (or lack thereof) by major investors:

We (major investors) don’t like checklists… It runs counter to deeply held beliefs about how the truly great among us- those we aspire to be- handle situations of high stakes and complexity. The truly great are daring. They improvise. They do not have protocols and checklists. Gawande, p.173.

Yet Gawande gives examples showing how professional investors who use checklists do better. As he says:

There was no question which style (of venture capitalists) was most effective. It was… the checklist-driven approach… p. 162-173

What are some common pitfalls

To avoid the dumbing-down risk identified by Etzioni, and to end-up being useful, rules of thumb and checklists themselves need to follow a few rules of form and content.

Avoid being too elaborate

… the most elaborate rules do not (on average) give the best outcomes. They advocate that a rule of thumb, as an easily learned and easily applied procedure for approximately calculating or recalling some value, is a better procedure than trying to obtain the best information possible. Burger-Helmchen , doc.1586 p. 16

Come from dubious or biased sources

Always be careful where RT’s come from. If a person or group has penned a RT, consider whether they have a vested interest (particularly financial) in advocating a particular point of view.

Exception to the rule

Rules, because they seek to simplify, are typically intended to apply most of the time. But 90% right is not all the time. Always consider whether your situation is outside the intended scope. Malkiel and Ellis in their excellent book The Elements of Investing, 2010, Wiley are unusual in so explicitly recognizing this. Their KISS portfolio is presented with the following caveat:

That’s why this chapter presents some very simple, easy to understand and easy to follow rules to help you achieve financial security. While some individuals have uniquely complex financial circumstances, we believe the rules we offer will work for almost all investors. And the portfolio we will present get’s it right for at leat 90 percent of individual investors. We leave out- on purpose- all sorts of complicated details that realy are just minor adjustments that might affect particular individuals.Malkiel and Ellis, p. 93

And if you are in the 10% of exception cases, they suggest seeking the help of a tax attorney or financial adviser. They insist (and we highly agree) that you will be better off doing so with a fee-only adviser, not one who earns commissions from selling you specialized investments.

We would add another caveat: avoid too easily concluding you are the exception to one of the rules we will be presenting. We all tend to think we are unique, but in the real world 90%+ of our problems have been confronted and solved many times before.

Conflicting or taken in isolation

Sometimes rules are ambiguous and conflict with each other, in which case judgment must be used. Etzioni gives the following example from the world of investing:

When individuals are provided with more than one rule, those rules often conflict with one another. For example, investors are told to 'buy low and sell high' (an ambiguous rule by itself, because no definition of either 'high' or 'low' is included and hence the rule invites investors to project their feelings on the situation). Sometimes 'high' or 'low' refers to price/earnings (P/E) ratios. However, what is a high ratio is not agreed and people are advised to invest in stocks of 'high-growth' corporations despite the fact that their P/E ratios are often infinite because they initially show no profit at all. Investors are also advised 'not to fight the tape' and to 'let their profits run but cut their losses short'. These rules suggest that if prices of stock move up, investors ought to expect them to move still higher, while if the prices fall- and hence are relatively low investors ought to bailout. These rules are incompatible with one another. Etzioni , doc.1587 p. 506 T

The danger is that when rules conflict people will follow the rule that coincides with their subjective estimates and own values. Etzioni, doc.1587 p. 507

Too elaborate

Sometimes poorly-thought out or drafted rules are more complex then the solutions they seek to address.

Too much information to process, limited intellectual capabilities, and values and emotions all curb the individual's ability to assess rules as it limits their ability to evaluate options. It might be said that there are many fewer rules than options and hence they are easier to 'process'. However, the evaluation 'of most rules is much more difficult than that of most options. Etzioni, doc.1587 p.509

Impractical rules

Sometimes rules are not easy to apply, as they are presented as complete or universal solutions, without adequate specificity. Rules are typically formulated as if they were universal truths, applying to all circumstances, to all times, and to all people. Etzioni, p. 509 Here again an example from the world on investing makes the point:

Another way to see that rules that culture offers are not rational is to see that they are often not sufficiently specific to provide guidance. Barron's publishes a weekly polling the 'sentiments' of traders in Treasury bonds and bills, expressed in percentage 'bullish'. But it always adds the note that 'high readings usually are signs of market tops, low ones, market bottoms'. Neither high nor low (or used) are defined. Hence, in effect, the weekly table provides a typical two-faced, highly if not completely, ambiguous rule. Etzioni , doc.1587 p. 507

The investing site Passioninvesting makes the same point:

Maxims and rules of thumb rarely express complete truths. Please be wary. Listen to maxims and rules of thumb. Do no come to accept them as gospel truths. Do not employ them in circumstances in which their core insight does not apply. 

Good and bad checklists

Gawande, in his book, The Checklist Manifesto, makes several observations of the common pitfalls of checklists:

The checklist cannot be lengthy. A rule of thumb some use is to keep it to between five and nine items, which is the limit of working memory. Gawande, p. 123 Good checklists, on the other hand, are precise. They are efficient, to the point, and easy to use even in the most difficult situations. They do not try to spell out everything- a checklist cannot fly a plane,. Instead, they provide reminders of only the most critical and important steps- the ones that even the highly skilled professionals using them could miss. Good checklists are, above all, practical. Gawande, p. 120, commenting on checklists in the aviation industry.

Conclusion

We hope we have whetted your appetite on rules of thumb and checklists. In our next commentary we look more specifically at rules of thumb and DIY investing, and how they can help in the holy grail of keeping things simple