How Simplicity Wins with Investing

Occam’s Razor is the idea that the simplest explanation is most likely the correct explanation. It sounds straightforward enough, but our struggle with this concept comes from how good our brains are at imagining.

“Extraordinary claims require extraordinary proof.” — Carl Sagan

There's a lot of examples of this in our day to day. When someone cuts us off in traffic, the simple explanation is that they didn't see us. Instead, our minds jump to the conclusion that they are jerks, intentionally driving recklessly to ruin our day. Something that is highly unlikely and a lot more complex than us simply being in their blind spot.

This mental reflex could be instinctual. Thousands of years ago, those who imagined the worst and reacted accordingly would be least likely to mistake a rustle in a bush from a sabre-toothed tiger as a rabbit. Acting quickly even if they ended up being wrong, was more important than acting slowly and being right.

Luckily for us, we don't have to worry about getting eaten during our day to day. But even though that's the case, our brain still operates as if we do. We turn simple explanations into extraordinary ones, even though it doesn't serve a beneficial purpose to us anymore.

There's few areas where this can be as disastrous as it can with our money. With our investments, there's three main ways where we look past the simple explanations in search of the extraordinary: our approach, our behaviour and our reaction.

Key Takeaways:

• The best approach is the one that is simplest for us to maintain for as long as possible.
• We have to behave in a way that prioritizes our long-term success over short-term trends.
• Aligning our understanding of normal with what actually is normal can allow us to react better.

Our Approach

Investing success is extremely unique in the sense that more time and more effort, doesn't directly translate to better results. We often believe that a more complex solution is a better solution, but historical data actually suggests that the opposite is true.

Looking back, in most years the majority of actively managed funds that set out to outperform the overall market, actually end up underperforming it, as seen below.

This is a result of many things, including the higher fees that typically come with complex strategies, but a large part is that no one knows what will happen. As much as we think or want something to happen, it doesn't actually make it any more likely to happen. Sometimes we make mistakes, and sometimes we get a negative outcome from a correct process. That's just life.

When it comes to our investments, longevity matters. We should establish our investing strategy in a way that's as simple as possible to maintain for as long as possible. The longer we invest for, the better the range of outcomes become. It's more about avoiding a big mistake than getting lucky.

Our initial approach can be as simple as investing in a single fund, or as simple as putting our faith in a portfolio manager. It's important to ensure that it's appropriate for our goals and risk tolerance, and that it's something that we believe in. We don't have to understand everything inside and out, but we should have confidence in our approach.

Our Behaviour

Research shows that most investors actually underperform the fund that they are invested in. Instead of being patient, and sticking to our plan, we have a tendency to chase performance.

Maybe I pick on ARKK too much, but it's a current example of the classic tortoise and the hare. A few years ago it was all the rage, and it seemed like if you weren't investing in the ARKK ETF, you were a fool. It seemed to have slayed the idea of indexing and value investing. Below compares its performance to the S&P 500.

The problem is that hot stocks cool off the fastest. Over the last five years, if you invested in a fund that followed the market, your money would have doubled. If you had invested in ARKK, today you wouldn't even have what you put in. That's not only a significant difference now, but an even larger difference when we look at the compounding potential moving forward.

This all ties back into our initial approach. When we set up our investments for long-term success, and understand our process, we can have confidence in it. We will be less likely to get pulled off track to chase something that goes against our plan. Sticking to our long-term plan is more beneficial than short-term luck.

The truth is, at every given moment, there is someone getting richer than you. That applies to everyone, and it's perfectly okay. The important thing to remember is that investing success isn't measured in a single moment, but is instead measured over a lifetime. There will be many times when the correct thing to do is also the hardest thing to do, and that is to do nothing differently at all.

Our Reaction

We have a tendency to believe that what we feel in the present is more important than anything we've felt in the past, or anything we will feel in the future. This recency bias causes us to weight events disproportionately to their significance. A negative news headline, something that really doesn't matter, can signal in our brain the end of the world.

Looking at historical data, we know that the majority of years experience a drawdown of at least 10%, yet we often view them as unique. Even drawdowns of 20% and 30% occur with a relative frequency, as seen below.

Despite these drawdowns, the stock market still averages incredible returns, returns much higher than what the average investor realizes. Research suggests that the more investors pay attention to and check their portfolios, the more likely they are to make a change that becomes detrimental to their long-term goals.

When we overreact to normal market behaviour, we can allow insignificant events to play significant roles in our own approach and behaviour. Short-term deviation from our long-term plan, rarely (if ever) results in a better future for our future self.

Investing is unique, it often requires behaviour and reaction that goes against our gut instinct: to buy low, to always hold, and to sell high. Where most investors go wrong, is they don't understand what normal is. By aligning our understanding of normal with what has historically been normal, as opposed to what we think the stock market should do, we can react appropriately to what's happening. A reaction that in most case is nothing at all.

How Simplicity Wins

Simplicity can take many forms, but at its simplest it means to choose a proven strategy and stick with it no matter what. We have to disconnect our perceived effort from our results. Someone could put in the same effort for 40 years, but every year's result will likely be different, at no fault of the investor.

In the short-term, markets will move against our hope. They know better than anyone that investing is a long-term pursuit. And that our success as investors is measured in decades, not days.

The trick is understanding that short-term market movements doesn't necessarily you're doing anything wrong, it isn't a reason for change. Sometimes markets just go down over periods of time. Chances are, if you're invested appropriately and your portfolio is down, so are the portfolios of most people. But we know that the longer we invest for, the better our odds become at the results we hope for.

Investors make the biggest mistakes when they become inpatient and try to force the result they want by complicating their process. In times of uncertainty or impatience, the best thing we can do is nothing differently.

If we approach investing with long-term success in mind, behave the right away, and ignore short-term headlines, in other words: if we keep things simple, we'll have much more success than we would by trying to complicate our strategy. Direction is so much more important than effort or speed.

Keep doing things your future self will thank you for.