Tuesday, October 16, 2018

The Illusion of Complexity

John C. Watkins, CFA®
Author position
Equity Portfolio Manager - Hilliard Lyons Trust Company

“Everything should be made as simple as possible, but not simpler.” - Albert Einstein

We live in a complex world. Rapid technological development is increasing the pace of change across industries. Global economies are ever more interconnected. Markets are deep, complex, and difficult to understand fully. Against this backdrop, a typical response is to fight complexity with complexity. Many investors believe they need investment solutions that are complex, nimble, and hyperactive. Investment managers who speak in complicated language are often perceived to have a better understanding of our complex world. Asset allocation keeps expanding beyond the traditional stock/ bond mix into alternative strategies such as hedge funds, commodities, options, private debt, venture capital, etc.

This desire for complexity is understandable, but we find it misguided. On the contrary, we maintain that simplicity, rather than complexity, is the best way to achieve your long-term investment objectives.

Simple ≠ Simplistic

Simple is often confused with “easy” and complex is confused with “sophisticated.” Wall Street preaches complexity because it is often easier to sell complex strategies and ideas. Intelligent people are attracted to complexity because, on the surface, simple solutions seem too obvious and unsophisticated.
Moreover, complicated strategies and ideas allow Wall Street and other investment providers to justify charging higher fees.

In his book, A Wealth of Common Sense, Ben Carlson states, “Simple doesn’t make for a compelling sales pitch. It’s not sexy. No one brags about simplifying their investment strategy to their peers. People assume simple means simplistic.” On the contrary, we don’t equate the two. We side with Leonardo DaVinci’s belief that “Simplicity is the ultimate sophistication.”

Complexity’s hidden costs

Complex investment solutions have considerable downsides. These “sophisticated” strategies typically charge higher management fees, implying they will provide stronger, less correlated returns compared to simpler strategies. In the most egregious cases, Wall Street hedge funds charge as much as 2% of assets annually and 20% of all investment gains. On top of this, the hyperactivity of complex strategies results in additional trading fees and taxes – directly eroding investment gains. Multiple layers of high costs create a nearly insurmountable headwind to long-term investment performance.

A subtler cost of complexity is behavioral. Complexity and transparency are inversely related. As complexity increases, investors’ ability to understand what is driving the strategy’s results decreases. That clouded understanding can result in panic during stock market stress or underperformance. Panic is detrimental to long-term investment returns. It leads to swapping in and out of different managers or securities way too often – or, worse, completely abandoning an otherwise sound investment plan.

Straightforward asset allocation 

Keeping it simple both in asset allocation decisions and in security selection decisions combats these problems. Simpler investment strategies are typically much more cost-efficient. They charge lower management fees. These strategies trade infrequently, minimizing transaction costs as well as taxes. Furthermore, simplicity promotes transparency and a deeper understanding of what is driving performance. This understanding minimizes panic and makes it easier to stick with a well-designed investment plan during periods of market dislocation or underperformance. In Charlie Munger’s words, “Simplicity has a way of improving performance through enabling us to better understand what we are doing.”

At Hilliard Lyons Trust Company, we strive to keep things simple and transparent in everything we do. Our asset-allocation framework is based on U.S. stocks, international stocks, and high-quality bonds. Even though the average institutional endowment fund has over 50% allocated to alternative investments, we eschew this asset class. Alternatives are costly and complex and have not been shown to increase returns over time. 

In individual equity selection, we take a long-term business-owner approach. We aim to own competitively advantaged businesses trading at reasonable prices run by talented people. We own these businesses for many years to allow for the long-term benefits of compounded returns. Finally, our bond portfolios are built to be diversified and high quality. This simple, understandable approach to investing has helped you, our clients, achieve attractive investment returns for many decades.

Simple ≠ Easy

While we believe simplicity is the cornerstone of intelligent investing, that certainly does not mean it is easy to implement. In fact, achieving simplicity is difficult because it demands discipline, the ability to tune out the daily news flow, long-term thinking, and an abundance of patience. We are constantly bombarded with opinions from TV pundits, social media, journalists, and minute-by-minute stock price fluctuations. In the face of this constant onslaught, our brains are telling us to act – DO SOMETHING, ANYTHING! Tweaking asset allocations or trading in and out of securities gives the illusion of control over the situation. In reality, most of the time these actions are simply incurring more fees and taxes without enhancing long-term return. 

This is not to say all trading actions are bad and portfolio changes should never be made. Any changes must be part of a well-thought-out investment plan rather than based on short-term stimuli. The key is to remain disciplined and patient, to stick to your investment plan, and to hold for the long term. In theory, this is simple, but in practice it is difficult. While the market is full of highly intelligent people trying to outguess each other in the short run, we think a singular focus on the long-term produces better results.

The illusion that complexity is required to provide spectacular investment returns in this complex world will persist. We continue to oppose this idea vigorously. We remain steadfast in our commitment to simplicity so that clients have a deep understanding of how we manage your assets. We will always prefer understanding and transparency to complexity and confusion. We are focused not only on helping you achieve your investment goals, but also on helping you understand the process along the way.
Past performance is not a predictor of future success. All investing involves the risk of loss.