Complex vs. Simple Investment Strategies

Many advocate a “back to basics” approach, from grade school educators to the food industry. Think about the original “Reading is fundamental” campaign to the farm to table movement. Simple is better. But is that true of investing? Hedge fund and many mutual fund managers that run “sophisticated” strategies would certainly disagree, but the truth is simple investment strategies outperform.

But don’t take my word for it. At Berkshire Hathaway’s Annual Meeting, Warren Buffett, arguably the most successful investor of all time said hedge funds are good for Wall Street, but bad for investors. He boldly suggested that “supposedly sophisticated people” and institutions are being “fleeced by hedge funds and their backers.” The Oracle of Omaha says, “there’s been far, far, far more money made by people in Wall Street through salesmanship abilities than through investment abilities.”

Buffett noted that the Vanguard Group’s S&P 500 index fund that tracks large American companies has beat a group of costlier hedge funds over time. Further stressing his commitment to indexing, during the financial crisis, Buffett bet the asset management company Protege Partners $1 million that the S&P 500 would outperform a portfolio of hedge funds over the 10 years through 2017. At his annual meeting on April 30, Buffet gleefully reported the index fund is beating the hedge funds by nearly 44 percentage points over eight years.

Because hedge funds’ consulting costs, management fees, and commissions will continue to eat up investment returns, investors don’t always get what they pay for. In investing, too, simple really is better. Yet, in their article, The Confounding Bias for Investment Complexity, Jason Hsu and John West explore the interesting fact that “the preference for complexity is almost hardwired into investors, their agents, and asset managers.” The thinking is that our complex global market requires a complex strategy. They write, “It only stands to reason (right?) that a sophisticated strategy is a requirement for mastering and benefiting from the intricate web of financial markets and asset classes. The globally integrated investment markets and economies are anything but simple, so it would not at first appear that a simple strategy could carry the day. The belief that simple relationships exist is absolutely counterintuitive to most casual—and sometimes, not so casual—market observers.”

To counter this point of view, Hsu and West cite research that shows that “simple, low-turnover and complex, high-turnover strategies perform similarly on a before-fee basis, suggesting the former may have the advantage after tax” and after-fee. They conclude, “We believe that making investors aware of the benefits of selecting a simple approach, strategy, or model is important. Unnecessary complexity is costly, not only directly (i.e., fees), but indirectly. Complexity can dampen investor understanding, which can lead to poor investment decision making so that an investor’s long-term financial goals are not achieved.”

That is, simplicity leads to better performance not only because in and of itself a simple low-cost approach produces better investment returns, but because when investors understand the strategy, they tend to stick with it, even in the wake of extreme market volatility like we experienced earlier this year.

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