Opinion

James Saft

In praise of simplicity

May 24, 2012

May 24 (Reuters) – It is perhaps the single easiest rule of
thumb in investment: favor the simple over the complex.

Complexity, whether it be 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 more
reliable than a Stanley Steamer.

The answer, of course, is that complexity favors 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,” Montier said.

Complexity when accompanied by its inevitable handmaiden,
the “expert,” is even more dangerous, he says.

Subjects in a behavioral 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 their brains that handle calculation
and probability turned out like a light.

MANAGING RISK

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 definitely 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 1 or 2 percent 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, favor companies that return
capital and be disciplined about buying and selling based on
valuation. All so simple, but so difficult.

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