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B. Venkatesh

MORE information can sometimes confuse when it comes to stock picking. Studies in behavioural finance show that people who pick stocks based on "recognition heuristics" can successfully outperform informed investors! What is recognition heuristics?

Suppose you want to buy orange juice. You would most likely choose a brand that you are familiar with. That is recognition heuristic or simply mental short-cut. It refers to the signal triggered by our mind to pick a recognised option over an unknown one.

Only people who are "beneficially ignorant" can apply recognition heuristics. If you were familiar with all the brands of orange juice, you will obviously not apply heuristic. Similarly, if you were not aware of any brand, there would be no recognition at all.

So, how can recognition heuristic be applied for stock picking? Suppose your friend is provided a list of 30 stocks and asked to pick five. Being "beneficially ignorant," he will pick stocks of five companies she knows by name.

Studies show that stocks picks based on recognition heuristics beat actively managed portfolios. There is a logical explanation for this. The study was conducted when the market was moving up.

Typically, large companies that form part of the index tend to do well in a market rally. And chances of picking such companies based on recognition heuristic are very high. Why? When we are "beneficially ignorant," we recall the names of the companies that are leaders in their business. And such companies form part of the market index.

What about market downturns? You can still employ recognition heuristic. But this time, you simply pick stocks that are unknown to you! For such companies, being smaller, typically do not decline as sharply as the index. Behavioural economists call such application of heuristics as "ecologically rational".

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