The above drawing is from The Naked Portfolio Manager and is illustrator Carolyn Schallmo's representation of what may go through a judgment-based manager's head before he buys a stock. It's a mysterious process: "Poof!"...and all relevant facts are processed and a decision is made.

As mentioned in my previous post, I had a chance last week to visit Sweet Briar College and review the progress of the class developing rules-based methods for portfolio management. After one student named Morganne Young explained her rational for selecting several different variables to construct her model, she asked an extremely profound question: "How do I determine how to weigh each of these variables in my model?"

Her question emphasizes yet another of the key advantages that statistical prediction, or rules-based decision-making, has over human judgment or intuitive decision-making. With statistical prediction, the model designer can use historical data to determine how much weight to give to each variable. With the "Poof!" process as illustrated above, it's unclear how the decision-maker weighs his inputs, or if he even gives any consideration to it at all.

Labels: Sweet Briar, variables