Systematic decision making is the creation of a process or model by which certain decisions are made and then actually following that process. While it seems like computer programming, it is commonly used in areas such as the military, sports, medicine and investing. We all have a tendency to go with our gut in our day-to-day lives, but there is ample research indicating that our gut is often wrong. Wesley Gray’s article titled The Case for Systematic Decision-Making goes into detail on why systematic decision making is often superior to gut-based decision making. Here are some examples:

  • A simple, two-part formula created by Joel Greenblatt for stock picking earned a 84.1% return over a two year span, but when people deviated from the formula by selecting among stocks that qualified to purchase and sell, their return was only 59.4% over that same span.
  • A metastudy across numerous disciplines on decision making by models/computers versus experts indicated that the models/computers beat the experts 94% of the time, with the experts winning just 6% of the time.

There are many reasons why following predetermined models is better than following our guts in many situations. We have so many biases in our decision making, including mood-based biases and recency or anchoring biases. We are also overconfident in our decision making skills (how many people think they are an above average driver?) and feel the need to justify our time and skill set in decision-making situations.

The end result is that we, as investors, need to create simple research-based models to tell us what and when to buy and sell. The worst thing we could do is panic in a downturn and sell low, or become euphoric in a bubble and buy high (which may be happening now). Once we have a model in place, we need to leave it alone as much as possible, as we tend to do more harm than good when tweaking the model. Here are some very simple models:

  • A low-cost portfolio for younger, more aggressive investors of 40% U.S. stocks, 30% foreign stocks, 10% bonds, 10% commodities and 10% real estate that is rebalanced once a year or if any portion of the allocation deviates more than 5% from its target, but is otherwise not altered based on market performance or expectations.
  • A momentum-based portfolio of exchange traded funds in which any trades are made monthly based upon preset and well-defined criteria and those criteria are strictly followed.
  • A low-cost buy and hold portfolio as described above, except that stock exposure is cut in half whenever the yield curve is inverted (i.e. shorter term bonds have higher yields than longer term bonds, a very bearish signal) and bond exposure is cut in half whenever the yield on bond holdings is less than the yield on stock holdings.

Mabene Faber has done quite a bit of research in this regard. He has analyzed numerous investing models and found that there are many that have historically beaten their corresponding index, so long as you actually follow the model. Again, the keys are to keep it simple and to actually follow the model.