Simplicity Beats Complexity in Investing

25 January 2016 | by Sean Stannard-Stockton, CFA

“I wouldn’t give a fig for the simplicity on this side of complexity, but would give my life for the simplicity on the other side of complexity.” -Oliver Wendell Holmes

In the wake of the market sell-off this month, investors are reminded just how complex the world is. From China to oil to interest rates to currencies, the number of cross currents buffeting the market is dizzying. However, in the face of complexity we believe deeply that the key to successful navigation of the financial markets is an investment process that is elegant in its simplicity. Too many investors try to fight complexity by adding even more complexity into their investment process.

The value of simplicity and the dangers of complexity have been highlighted by people as varied as Steve Jobs, Leonardo da Vinci and Bruce Lee. Now a new research paper from Rob Arnott’s Research Affiliates demonstrates the detrimental effects that complexity has on investment performance. The paper, titled The Confounding Bias for Investment Complexity, argues that investment firms often sell complex strategies in order to justify higher fees, but in fact simpler strategies result in investor behaviors that enhance returns.

The paper makes the following key points:

  1. A preference for complexity is almost hardwired into investors, their agents, and asset managers because the intuition is that a complicated investment landscape requires a complex solution; a complex strategy also supports a higher fee from both agents and managers.
  2. Research shows that simple, low-turnover and complex, high-turnover strategies perform similarly on a before-fee basis, suggesting the former may have the advantage after tax.
  3. Simplicity leads to better investor outcomes not because simplicity in and of itself produces better investment returns, but because a simple strategy encourages investors to own their decisions and to less frequently overreact to short-term noise.

Another way to put this is that making smart investment decisions requires building the conviction needed to stick with your strategies even during times of material underperformance. All great investment strategies experience periods of underperformance. When the strategies are complex, investors can come to question the strategy during difficult periods. More simple and understandable approaches are much easier to build conviction in and stick with during these same periods.

When Warren Buffett talks about many investments going in his “too hard pile” he’s freely admitting that even for the greatest investment mind of our time, many investment opportunities are just too complex. It is to the avoidance of these ideas that Buffett attributes much of his success.

Periods like we are in today cause all investors to question their assumptions. That’s a good thing. Investors should continually question their assumptions. But if the current environment has you suddenly questioning your investment strategy, you should evaluate whether that is because of unneeded complexity rearing its ugly head.

While we do not accept public comments on this blog for compliance reasons, we encourage readers to contact us with their thoughts.

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