Investors, Keep It Simple

Before I begin this week’s commentary, I want to briefly discuss the recent decline in stock prices. Volatility increased with blazing speed; the six-month trading range for the S&P 500 index jumped from 4.44% as of August 13 to 14.09% as of Tuesday’s close. China, uncertainty over a change in monetary policy, worries about economic growth and seasonal patterns (September has historically been the weakest month of the year for stocks) have all combined to push stock prices lower. Plus, the market had simply gone through an extended period without enduring a correction, so a notable drop was bound to have occurred sooner or later.

Some of you have viewed this as a buying opportunity. Others are viewing it with concern. If you are in the latter camp, I encourage you to consider two things. First, the speed at which volatility has returned shows how difficult it can be to correctly time the market. If you didn’t reduce your stock holdings in May or June, ask yourself: Why should you have confidence that you’ll know when a bottom to the current correction has been reached? Second, the odds of stocks being higher five years from now are very good; the Ibbotson SBBI Classic Yearbook shows that large-cap stocks have realized gains during 86% of all rolling five-year periods since 1926. The odds get even better as stocks are consistently held for longer periods of time.

I realize it can be tough to embrace the uncertainty, but the long-term gains from stocks will reward you for staying with them. In the shorter term, keeping a large enough allocation to cash and short-term securities to cover living expenses and other emergencies (money needed for the next three to five years should not be invested in equities) can help give you the confidence to stick with stocks throughout the current turbulence.

There is much to be said for maintaining a level of simplicity when investing. This is particularly the case if doing so allows you to stay focused on your long-term process. The trade-off is the possibility of following a strategy with lower potential returns. However, the strategy with lower potential returns may help you build greater wealth in the long run if it is easier to stick with than a more complex strategy with potentially higher returns.

There are several reasons why this is the case (including more than I discuss in this week’s commentary). One of the biggest is what researchers refer to as “bounded rationality.” Bounded rationality, in economic terms, is the limits of our ability to make utility-maximizing decisions. It is the limitations created by our cognitive abilities, knowledge, emotional tendencies and available time to formulate the most profitable course of action given what is known at a certain point in time. The more complex a strategy is, the more likely we are to bump up against bounded rationality. This in turn can lead us to make suboptimal decisions.

A related concept is often referred to as “paralysis by analysis.” This admittedly non-academic phrase refers to the difficulty of making a decision after having gathered too much information. Though there are certain characteristics you should look at when evaluating, say, a stock (valuation, profitability, financial strength, etc.), there is a point where gathering more information not only yields less incremental benefit, but can actually do more harm than good. An oft-cited study by Sheena Iyengar and Mark Lepper showed how too much information—or, as in the case of the study, too many choices—can lead to inaction. Consumers were less likely to buy jam when presented with 24 choices of jam than only six choices.

In addition, it is easy to get distracted by focusing on the wrong themes. Every once in a while I will get a question about some specific market event, fundamental/technical analysis indicator or economic data point that leads me to wonder why someone is focusing on it. It’s human nature to seek out patterns and/or explanations. It’s much harder to embrace uncertainty. Plus, though market anomalies continue to exist, the likelihood of identifying a new one—particularly a short-term one—is very small. This doesn’t mean that you can’t still benefit from exploiting existing anomalies, but rather that anything seemingly new that you or I come across likely has a high probability of having been identified by an institutional investor with more capital and faster computers.

Then there is the matter of complexity. The greater the number of rules to follow and the more data that must be monitored, the tougher it will be to stick with a strategy. Building on last week’s commentary about the link between wellness and investing, I suspect the reason so many diets fail is that they are too hard for people to stick with. It’s always easier to follow a strategy when the strategy is easy to follow.

The right level of simplicity varies by person. A 2013 webcast between University of Chicago professor Harold Pollack and journalist Helaine Olen received some press earlier this summer for Pollack’s assertion that a person’s investment strategy should be able to fit on a 3”x5” index card. In response to the webcast, he published a blog post showing his financial strategy completely fitting on an index card (albeit a 4” x 6” index card).

While I don’t think people should feel compelled to limit themselves to an index card, I do think a good rule of simplicity comes to down to answering a very simple question: How easily can you explain your strategy to someone who is completely unfamiliar with it? If you need to spend a significant amount of time doing so, you either need to simplify your strategy or have a plan B that your spouse or someone else you trust can easily follow should they need to suddenly step in and manage your finances. Better yet, see how quickly and easily you can write down your strategy. If you can’t do it quickly, it’s another sign that your strategy is too complex.

Keep in mind that perception of complexity varies by individual. A target date fund can be a great investment for an investor who desires a single investment choice or lacks the knowledge to make asset allocation decisions. An investing strategy requiring a stock screener or a related computer program may work well for investors with greater expertise and time. In between is a wide magnitude of strategies. Regardless of where you fall within the range of complexities, you should always be able to easily explain your strategy to others.

A good rule of thumb is to simply ask yourself how often you haven’t done anything because of a lack of time or ability to make a clear-cut decision. If you’ve found yourself procrastinating, it could be a sign that you need to simplify your strategy. After all, the optimal strategy is always the one you can stick with over the long term.