The Hindu Business Line : <I>Recognition heuristics </I>

John, an acquaintance, recently won a prize. The participants in the game had to build a portfolio of stocks. The portfolio returns were compared with the average returns of five money managers. A participant who generated the highest return above the average returns of five money managers was declared winner.

John beat the average by three percentage points. He simply picked out stocks that he was familiar with. Fortunately, he knew only large companies and just ten of them. Both factors worked in his favour. Research in portfolio management has shown that it is enough to buy 10-15 stocks to reduce your risk. The important factor was, of course, his strategy to pick out stocks that he was familiar with. This strategy of basing your decisions on familiarity is called recognition heuristics.

Heuristics is a method of taking decisions. Recognition heuristics means taking decisions based on information that you are familiar with.

In one study on recognition heuristics, Turkish and English students were asked to predict the outcome of 32 English soccer matches. Turkish students selected the likely winners based on their familiarity of the cities and clubs in England. Though their knowledge of the English soccer clubs was very limited, their forecast was more accurate than that of their English counterparts!

Of course, this does not always mean that knowing less is better.

But it does mean sticking to ones that you are familiar with could pay off. This rule is especially true in the stock market. It did work for my acquaintance, who now thinks he is better than most money managers!

(The author is based in Toronto, Canada)

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