29 August 2016

Beware the lure of complexity

We live in a bafflingly complex world, and we tend to assume, wrongly, that complex problems require complex solutions. Often the best way to deal with a complex issue is to reduce it down to its bare essentials — to make it as simple as possible. Investing is a classic example.

Many investment professionals love complexity. Indeed, many firms see it as their value-add. That, combined with a lack of investor education, is how they make their profits. To quote a former Goldman Sachs money manager, “the quickest way to make money on Wall Street is to take the most sophisticated product and try to sell it to the least sophisticated client”.

We already have far more investment products than we actually need. There are now upwards of 77,000 mutual funds to choose from worldwide — that’s more funds than individual stocks. Then there are hedge funds; what used to be a cottage industry is now a global one, with more than 11,000 different funds to choose from.

Meanwhile, in the ETF sector, competition is hotting up to produce the most obscure and complicated products imaginable. To quote Ben Johnson, Head of ETF Research at Morningstar: “There’s no more white space up on the board. All the valuable real estate has been occupied, so it’s now just flinging spaghetti at the wall and seeing what sticks.”

Of course, all these new funds need explaining and evaluating, hence the need for armies of analysts and consultants. This proliferation of products also helps to explain why, at a time when most of the journalism industry has contracted, the financial media has grown.

But although complexity is the industry’s friend, it’s usually the investor’s foe. In his book A Wealth of Common Sense: Why Simplicity Trumps Complexity in Any Investment Plan, Ben Carlson writes:

“As the number of investment options available to investors continues to increase there is the assumption that complex approaches must be better. In fact, less is always more and trying to implement a more interesting or clever portfolio strategy is akin to threading the needle. Sure, it can work, but trying harder and increasing the number of decisions you make only increases the odds that you’ll make a mistake.”

Yes, the financial markets are hugely complex, but a complex portfolio is not the answer. On the contrary, the simpler your strategy the better.

But Carlson goes on to explain how, counter-intuitively, it’s actually easier (as well as commercially beneficial) for the investing industry to maintain its culture of complexity. As Nassim Taleb explains in his book Antifragile:

“A complex system, contrary to what people believe, does not require complicated systems and regulations and intricate policies. Yet simplicity has been difficult to implement in modern life because it is against the spirit of a certain brand of people who seek sophistication so they can justify their profession.”

So, what does a simple investment strategy mean in practice? It starts with acknowledging complexity — accepting that markets are subject to so many forces we don’t understand or even know about, and that no one ‘expert’ can possibly know what’s going to happen in the future and how the markets will react.

A simple investment strategy also means embracing what we do know. Independent, peer-reviewed evidence shows us, for example, that diversification is very important, that low-cost funds in aggregate outperform high-cost funds, and that the less we do as investor the better our long-term returns will be.

But it’s one thing implementing a simple plan and quite another sticking to it. “The hard part about being in the simplicity game instead of the complexity game is all mental,” says the investment blogger Josh Brown. “At any given moment, there will always be a complex solution gaining adherents and making outsiders look as though ‘they just don’t get it’.

What simple investing also requires, then, is discipline — reminding yourself, when tempted to try something more sophisticated, that you chose simplicity for a reason, and that the reason is as valid today as the day you made that decision.

In investing, simplicity really is the ultimate sophistication.

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