Complex vs. Simple Investment Strategies II

Peter Lynch ran the Fidelity Magellan Fund for 13 years, during which time Magellan was the number one general equity fund in America. Lynch’s books One Up on Wall Street and Beating the Street offer up the active manager’s accumulated wisdom. Lynch sums up his points in Beating the Street with his humorous “Peter’s Principles.” I think the most meaningful in our complex world may be “Never invest in any idea you can’t illustrate with a crayon.”

3d render of zigzag vs straight road depicting complex and simple pathsThat rule of Lynch’s has been reported this way. “A class of seventh graders at an American primary school did a social studies project on stocks, the kids had to do their own research and dig up stocks for a paper portfolio. They sent their picks to Lynch, who later invited them to a pizza dinner at the Fidelity executive dining room, illustrating their portfolio with little drawings representing each stock. Lynch just loved this because it illustrates the principle that you should only invest in what you understand, the kids portfolio consisted of toy manufacturers, makers of baseball swap cards, clothing manufacturers and outlets, Playboy Enterprises (a couple of boys chose that one), Coke, and other stocks of that ilk. With a portfolio notably lacking in glamorous technology ventures and entrepreneurial risk taking they went for solid stocks with excellent profits, their portfolio returned 69.6% versus 26.08% for the S&P 500 Index in 1990/91.”

What makes that advice so difficult to follow? In “The Confounding Bias for Investment Complexity” Jason Hsu and John West explore the notion that a preference for complexity is “hardwired into investors, their agents, and asset managers because the intuition is that a complicated investment landscape requires a complex solution; a complex strategy also supports a higher fee from both agents and managers.” Their research shows that simple, low-turnover investment strategies and complex, high-turnover strategies perform similarly on a before-fee basis, suggesting as all research does that simple passive strategies have the advantage in many asset classes. However, the researchers take their analysis one step further than reporting on after-fee performance. They conclude that, “Simplicity leads to better investor outcomes not because simplicity in and of itself produces better investment returns, but because a simple strategy encourages investors to own their decisions and to less frequently overreact to short-term noise.” Think about the kids investing in toy makers and Coke.

Especially in a complex and challenging market like today’s where political uncertainties reign supreme and ongoing volatility tempts investors to abandon their strategies, it can be helpful to simplify investment plans so investors feel more comfortable remaining invested as the market continues its roller coaster ride.

Of course, favoring complex strategies is often thrust upon investors by asset managers and financial advisors who figure they can charge more for providing some kind of secret sauce strategy. All you need to do is look at hedge funds’ recent performance to see that, as in the Land of Oz, mere mortals operate behind the wizard’s screen! To paraphrase Shakespeare, these high risk strategies amount a lot of sound and fury, signifying nothing!

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