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Keep it simple, stupid

Complex systems

Human beings love complexity. There are more complex ways to put it, but as this post makes the case for simplicity let’s start as we mean to go on.

I argued recently that the stock market had fallen lately because it had gone up a lot, fast. We’d got carried away.

“What rot! I don’t subscribe to Monevator to read what my six-year old could tell me! I want to hear about sovereign debt defaults, plunging leading indicators, and a death cross price pattern!”

Okay, nobody wrote that to me but that’s how many people treat the market and economics. Just watch an hour of CNBC for proof.

Now I’m not here to say that markets or economies aren’t complicated. They are true complex systems.

What I do think though is that complex answers are more about fitting our idea of what’s a suitable class of explanation, rather than about being right.

In reality, the best answer to most stock market questions is: “I don’t know”.

Kids think complex

Our bias towards trusting complex solutions seems hardwired from birth.

I spent part of this week at Culture Evolves, a conference in London organised by The Royal Society. Anthropologists, sociologists, and various other –ologists discussed whether ideas and language evolve in a similar way to genes.

One session highlighted ‘over-imitation’ in children. The gist was that as kids we learn by imitating other people, but – unlike chimpanzees, notably – we’re sometimes prone to copying redundant activities, too.

Derek Lyons spoke about this research. It involves training four-year old kids to ignore witless adults, and then recording how the kids later extracted a prize from various toy-based puzzles:

Two of the entirely legal child-tormenting devices

Derek found that if just given the puzzle without adult guidance, the kids set about finding the quickest way to extract the prize.

However if kids first saw an adult doing dumb things like waving feathers, removing pointless struts, or tapping a box with a pencil before opening the door to the prize, the kids copied the redundant acts, too.

It seems that kids who first see an adult solve the puzzle are assuming the toys are more complex than they appear – that there must be hidden mechanisms that explain why these seemingly dumb actions are required:

  • If researchers joined two toys together with a section of pipe and did dumb things on one before taking the prize from the other, the kids copied them.
  • If the pipe was removed – disconnecting the two set-ups – the kids correctly assumed the adult was wasting time on the other toy, and went straight to the one with the prize.

Importantly, we continue to over-imitate as adults.

For example, if you don’t know anything about cars and you watch a mechanic check various parts of your engine before topping up your oil, there’s a good chance you’ll perform the same needless checks when you fix the oil yourself.

Similarly, if you’re an investor and you read or watch apparently informed market pundits, you’ll soon believe the FTSE fell by 0.2% because German government bonds are rising in reaction to saber-rattling in Iran, or similar nonsense.

Before you know it you’re trading noise like everyone else.

Dumb money is smart money

As investors, we should try not to assume that complicated products or explanations are always required, let alone superior.

Financial markets are complex systems. They are analysed by well-paid and clever-sounding adults who read charts, follow company results, and insist that investors should put 10% into palladium futures or Korean bonds.

Mostly we’d be better off ignoring them and sticking to a very simple plan. But it takes real understanding to appreciate that clean, cheap products in investing are usually better than expensive and complicated ones:

  • Active funds are more popular than index trackers, even though trackers have been proved to outperform most managers. It’s hard to trust dumb tracking.
  • Asset allocation is a very imprecise art. The easiest thing to do when you’re ready to move beyond the cash/tracker combo is to pick a simple ETF mix and rebalance annually. Complex financial models will suggest you need 3.653% of your money in this or that. You don’t.
  • Banks love to sell structured products because few customers understand how they work. (They’re actually based on derivatives).

Academics have even discovered that High Street savings accounts and mortgages are made deliberately more complicated to confuse us!

Takes one to know one

Perhaps you’re immune from favouring complexity, but I doubt it.

I’m financially literate, yet I still pick shares with a proportion of my portfolio. It increases the time dedicated to investing at least ten-fold, and the jury is still out on whether it will make me richer. The academic evidence says it won’t.

True, I claim I do it for fun. But there are other challenging things I could do for fun instead. I could become a cultural anthropologist, for instance, which on the evidence of the conference I attended is interesting and involves a lot more attractive women than share investing. (Give me a break – I’m recently single!)

In my experience, most people who get into the markets eventually buy some shares or active funds. Even if they know better.

K.I.S.S.

The real cardinal sin is to invest in something you don’t understand instead of a straightforward product that you do.

A great example are income investment trusts, which fluctuate with the stock market like any other shares, but have a very good track record of delivering a growing income over time.

People wary of the stock market shun these trusts, and instead buy expensive pseudo-bonds that deliver a crappy return and too frequently blow-up or result in a miss-selling scandal.

Other examples of over-complication include foreign currency mortgages, guaranteed equity bonds, and bundled life insurance products.

Shun them all, and keep it simple, smarty!

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{ 11 comments… add one }
  • 1 Everyday Tips July 2, 2010, 1:58 am

    Very interesting post. I refuse to ‘buy’ anything, since so much investing can be done online. I remember when this guy from Primerica was trying to get me to buy all his ‘loaded’ products, and he tried explaining to me how his managed services were worth the costs, blah blah. No thank you. I personally like my Vanguard index fund and other ‘low maintenance’ investment vehicles. I don’t buy puts or options, I am very basic. I am sure I might be missing opportunity, but I want to know enough about what I am investing in so I can get out of it if I feel it is necessary. I don’t want some guy that talks to me once a year to try and talk me out of things for his own benefit.

    With the market the way it is now, I don’t think anyone knows anything, including me.
    .-= Everyday Tips on: Keeping Things In Perspective… =-.

  • 2 Gabriela July 2, 2010, 10:53 am

    Sad part is that even the salesman who peddle these ‘investment opportunities’ don’t really understand how they work. Once I had amusing conversation with one of these advisors at my bank….and yeah, as we saw in regards to CDOs, sometimes even the big heads who structure those vehicles don’t really understand them (but at least they are usually smart enough not to put their own money in it).

  • 3 Aury (Thunderdrake) July 2, 2010, 6:35 pm

    I’ve always been an advocate of teaching things simply.

    I think one of my biggest foibles is that I tend to get pretty wired up in complexities of when I try to teach people.

    Reminds me that I should perhaps do a laconic rendition of a few series I wrote out…
    .-= Aury (Thunderdrake) on: Movie Review- Prince of Persia- Sands of Time =-.

  • 4 ermine July 2, 2010, 7:11 pm

    The trouble for me as relatively uninformed is that it is hard for me to understand how investment trusts are different from other managed investments. I’ve taken on board the ETF approach and the vast majority of my holdings both pension and ISA are ETFs. Your investment trust post was intriguing and I’ve had my eye on Merchants Trust for a while because of the lovely yield of nearly 7% at the moment.

    Tax-free income is what I need in the near future, and this would appear to deliver. I haven’t moved yet because I still can’t understand what the heck I am buying. I’d love the steady income, but I have no idea of how they manage to do that. So investment trusts still fall into the complex bucket for me.

    Sorry to hear of your change of status…
    .-= ermine on: Cameron Tells Us to Get On Our Bikes- The World Doesn’t Owe Us a Living =-.

  • 5 Barb Friedberg July 3, 2010, 3:10 am

    Hi! This post is absolutely correct! Modern Portfolio Theory and volumes of evidence recommend simple asset allocation in diverse index funds. The 40 page Elements of Investing by brilliant Malkiel & Ellis cover it all. You are so on the money! Best regards, Barb
    .-= Barb Friedberg on: THE FINAL TALLY “Catfight of the Personal Finance Blogger Chicks” =-.

  • 6 Macs July 3, 2010, 1:13 pm

    I’m definitely one for simplicity too! I think the one piece of investment advice that has rung truest with me is the ‘don’t invest in what you don’t understand’ principle. I think I fairly well understand that buying stock in a company is a way to participate in ownership, and if it’s the right company, this at least offers you a slice of the profits by way of a dividend. This is simple – you buy a chunk at what looks like a good price for the promised share of the cash-flow. If the situation changes, then reconsider… For that inflation-hedging, wealth-preserving asset class of precious metals, I like sovereigns in my hand rather than shares in what may or may not be in a vault somewhere, or a certificate which I’m told has the ‘same value’ as gold. Again, simple wins out IMHO.

    Another thing I’ve learnt looking across various forums and products is that what often distinguishes between good or poor products is actually the fees, not the ‘fundamental performance’. Fees increase with complexity, so again simple tends to win out.

    And finally, a lot of these complex products with big fees are, as so eloquently stated above, deliberately opaque, so poor muggins really has to rely on the managers, agents, whatever. And I strongly suspect that a lot of the fees amount to nothing more than paying someone to wave feathers around and maybe tap boxes if they’re really good.

  • 7 The Investor July 5, 2010, 11:47 am

    @ermine – I presume my article on income investment trusts (and the previous introduction) weren’t sufficiently illuminating? (Er, not meant in a sarcastic way, if that’s how it sounds – just checking you saw them).

    Basically investment trusts get a higher income by:

    • buying company shares paying a higher than average (or fast growing) dividend (so yield more than the index on average)
    • sometimes gear up (borrowing to invest) so increasing the yield again
    • sometimes selling shares to turn capital gains into dividend income
    • sometimes trade at a discount to net assets (so the same dividend income stream can be bought more cheaply)

    The upside is a higher average yield, and hopefully a sustainably growing one long term.

    The risks are under-performing the market (since just buying yield shouldn’t in itself be a signal for outperformance, and theoretically all active strategies should underperform the index long term) and also more immediate risks introduced by the gearing and discount (though for big, diversified trusts you can usually expect to ride through this, provided you’re comfortable with a volatile share price).

  • 8 ermine July 5, 2010, 2:45 pm

    It was your articles that warmed me up to the existence of investment trusts 🙂 The almost monotonic increase in dividends is attractive because I am looking to buy an income. Previously I’ve been holding IUKD but the income stream is quite variable and not really suited to my requirements.

    The issue is that these are active investments, and I have no experience of active trusts and about ten years of ‘avoid active funds’ mantras ringing in my ears, plus having got burned in with-profits mortgage endowments, which were supposedly an attempt to smooth investment returns. So I’d be rowing against these principles. But that income history of 20 years+ dividend growth has some serious attraction and looks almost too good to be true. I just haven’t found the catch yet!
    .-= ermine on: Why Office Work is Bad for You – Reprise =-.

  • 9 The Investor July 5, 2010, 3:23 pm

    Catches as explained above! 😉 Also, there’s a chance of some black swan event as always, though it’s hard to think of one that wouldn’t also effect dividends from the market. (E.g. Swingeing taxes on dividends). I’d diversify between at least 5 trusts to get away from management/company risk.

    IUKD is not at all suitable for a growing dividend stream. It’s more like a mechanical recovery fund, where yield is the value signal.

  • 10 The Investor July 5, 2010, 3:26 pm

    p.s. If income trusts dividend income/increases are going to flounder every now and then, then keep in mind we could be entering such a period.

    They are currently drawing down reserves accumulated in the good years to make up for the demise of bank dividends, and they’ll have to do something about BP (though Woodford’s trust avoided oil (Ticker EDIN — has some expensive debt though)).

    So if you buy, you’d want to do so knowing increases could flatten or the income could even dip 10% or so for a year or two. (This is aside from market risk, where if the stock market halves, your ITs will certainly fall similarly, too – maybe a bit more, or a bit less, depending).

    NOT meant as personal advice, even for a regular reader! Please keep doing your own research. 🙂

  • 11 ermine July 5, 2010, 9:31 pm

    Much appreciated, and of course I take full responsibility for my own cock-ups 🙂

    IUKD certainly showed its variability and isn’t right for my aims, which is for an income for about 5 years form 2015. I have a ladder of NS&I linkers for some years before that. An income dip of 10% is a staid affair compared to the ETF white-knuckle ride. Thinking about it, my Dad used investment trusts when he retired to turn his lump sum into an income. I should have paid more attention then!
    .-= ermine on: Why Office Work is Bad for You – Reprise =-.

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