Friday 23 February 2018

It's the easiest rule for investment: favour the simple over the complex

IT is perhaps the single easiest rule of thumb in investment: favour the simple over the complex.

Complexity, whether it is in a strategy or in a financial product, makes investors vulnerable: to being overcharged, to misunderstanding risks and to being unable to exit the position easily and economically.

To understand why this is true, on so many levels, look no further than JP Morgan's chief investment office disaster. It involves a trading position which, despite being put on and overseen by people who ought to be the best in the world, landed the bank with a loss that is almost literally unquantifiable.

The advice that Morgan shareholders wish the bank had followed holds true for individuals as well: don't invest in anything you can't understand.

In fact, take it a step further -- if you have to even consider whether you understand an investment, just walk away.

On its face, the appalling track record of complexity in the investment industry is a puzzle. After all, jet engines are more complex than what the Wright brothers used and a Prius is more reliable than a Stanley Steamer.

The answer, of course, is that complexity favours those who structure and sell investments over those who merely commit capital to them, increasing the already dangerous lack of alignment between investors and their financial providers.

The rewards to the industry for pointless (for the investor) complexity far outstrip the rewards of actual outperformance.

"In finance we love to complicate. We love to over-complicate. We rely on complexity to baffle, bamboozle and generally thwart human understanding," James Montier, of fund manager GMO, told a conference hosted by the CFA Institute earlier this month. "Complexity impresses, it allows people to charge high fees, it keeps outsiders out," Mr Montier said. Complexity, when accompanied by its inevitable handmaiden, the "expert," is even more dangerous, he says.

Subjects in a behavioural investing experiment were hooked up to a brain scan and asked to choose between a safe asset and a more complex one that was essentially a lottery.

Half the subjects had the "benefit" of having the choices explained by an expert. Inevitably, it was found that while the experts spoke, the parts of the subjects' brains that handle calculation and probability turned out like a light.

Prime among the reasons for avoiding complex investments is that they make it much harder to understand the underlying risk. While Jamie Dimon believed, and still believes, that he can control complexity risk through sheer excellence, he was proven wrong. You, dear reader, are almost certainly both less well-resourced and less excellent than Mr Dimon.

Secondly, of course, is the fact that complexity makes it easier for the experts to benefit themselves without cutting the owner of the capital sufficiently in on the benefits. Just as banks are forever getting burned by traders seeking big bonus payments, so fund holders are vulnerable to paying too much in fees when they choose complex products. It is far easier hiding an extra layer of fees in a complex options-based mutual fund than in a tracker.

Complexity breeds activity like a swamp breeds mosquitoes. Complex products, by their very nature, tend toward being active products, executing more trades more often. This may or may not benefit the investor, but does create a stream of income for brokers.

There are very few things in investing that you actually control. What you pay for investment management products is one, and as such should probably be top of your list on what to concentrate on to improve your outcome. This is especially true in times of low returns, as an extra 1pc or 2pc in annual charges in an era of low inflation and low returns is all the more damaging.

Keeping it simple is one of the easiest ways to control costs.

And, as there is absolutely no sustained record of evidence to support the idea that complexity produces better outcomes, sticking with a prejudice for the simple over the complex is one of the easiest ways to improve long-term outcomes.

Of course, the truth is, in Warren Buffett's famous dictum, "Investing is simple, not easy."

Just like losing weight, the issue is not the strategy but the execution. Keep costs down, favour companies that return capital and be disciplined about buying and selling based on valuation. All so simple, but so difficult.

James Saft is a Reuters columnist

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