Simplification of reality

11Mar07

Economic modelling seems to be taking over the world. Books like Freakonomics have made the application of econometric tools to topics that seemingly diverge from the typical fare of economic journals downright fashionable. One of the interesting (to us) applications of economic modeling is sports.

Even in sports like baseball where there is a long history of keeping detailed statistics there have been even recently opportunities to use better models to make player decisions. This was documented to great effect in a book like Moneyball.

Focusing primarily on another sport, basketball, David Berri along with his co-authors at The Wages of Wins Journal, have applied economic models to player performance. They have found some interesting statistical relationships that take aim at some traditional thinking. We recommend the site to any one interested in the topic.

In a recent post Berri discusses the larger idea of using economic models to better understand behavior in other fields like political elections. While models are indeed powerful tools they can also be poorly implemented and misapplied. For investors it can be helpful to think about models in a different context altogether.

I note the work of Fair because I think his work illustrates the task models are supposed to accomplish. A model is supposed to be a simplification of reality. And why do we need simple? Because when us human beings try and make sense of our world (so we can do stuff like make decisions) we tend to take what is very complex and simplify. If we did not do this, decisions would be extremely difficult to make. Given how we make decisions, a good model is most helpful when it allows us to simplify “correctly.”

We have discussed previously the temptation of excess choice and model building. In it we noted that in a world of nearly infinite indicators, fundamental and technical, there is an inherent temptation to try and build the ultimate model that explains everything. This is however a false choice, as Berri writes:

The temptation in doing analysis – whether it is elections or basketball – is to consider everything that anyone thinks could matter. Models, though, are not supposed to consider everything. Models are supposed to be simplifications of reality that allow us to focus on the factor or factors that truly are important.

In short, investors of all types need to focus on those factors that truly matter. Focusing on extraneous things like most of the media, read CNBC, will only serve to make your investment process less robust. However, model building in and of itself is no panacea. Trying to create a model that is “right” as opposed to “good” will only serve to complicate your investing life. Investors can take a hint from related fields and topic to focus on what is important in their investment processes.

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