Avoiding Complexity Bias

Complex strategies draw in investors but do they add value and alpha?

A couple of interesting tidbits I found for today's blog post. Farnam Street had a fascinating post about complexity bias. It is a long read but the short version is that when given the choice between the simple and the complex, it is human nature to choose complex for believing that complex must be better. The article lists plenty of reasons why this might be, and while I would encourage you to read the article, if you think about it, you've probably succumbed to this before.

The idea of simplicity is something I have written about many times, long before I ever heard of complexity bias. It is useful in life of course and more narrowly it is crucial to investing. If you have ever heard about over-trading an account generally leading to poorer returns than just buying and holding, an active trading strategy is clearly more complex than buying a couple of broad based funds and rebalancing every so often. The more activity there is, the more chances there are are to be wrong. One reason for this is the tendency for stocks to go up over the long term. If you don't think that can continue, a lot of people were worried about this ten years ago, then you should probably get out now.

In the last 20 years the SPDR S&P 500 (SPY) is up 195%. It doesn't get much simpler than buying one broad based equity fund. Someone who bought that fund 20 years ago and bought more with each paycheck is up dramatically more than the static 195% from the initial purchase. The last 20 years included two pretty good sized calamities and still the market is up a lot. I am not saying it is impossible to succeed (outperform) but the starting point is understanding that doing very little (keeping it very simple) has an extremely high probability of working. If time is money, do you want to make it more than a full time job to get an average of 2% of alpha every year (huge stretch as no one outperforms every year).

Do you have a $1 million portfolio? Last year the S&P 500 was up 21%. Just owning SPY would have meant a $210,000 gain. A full time trading endeavor leading to an extra 2%, so making $230,000, would equate to an extra $20,000. That is a helpful amount of money but as a tradeoff as being a full time endeavor, is it worth it? That is up to the individual but not too many people view $20,000 for a full time job as being lucrative.

The context of this post so far is the complexity of shorter term outperformance. I differentiate that objective from building a diversified portfolio, not just one fund, with exposure to different equity market segments and different asset classes to manage things like volatility to (hopefully) make it easier for clients to ride out the entire market cycle. This has been a huge building block to how I manage portfolios. I view what I do in this regard as being simple as I build portfolios with a mix of ETFs and individual issues, I use one or two traditional mutual funds too but the big idea is that these are investment products easily accessed and understood. Someone who doesn't think narrower ETFs and individual stocks makes for a simple portfolio should then use more broad based products.

A current event that addresses this concept is what is happening with Bill Ackman and his Pershing Square hedge fund. He's lost money as the market has raged higher, he is cutting staff. He's made some loud bets including against Herbalife (HLF) which in the last three years is up 130%. Whatever went into the decision to short HLF, it is a decent bet that it was far more complicated than buying SPY and dollar cost averaging in every paycheck. It would be reasonable to think that the pitch for any hedge fund might include an investment process that others can't do, arguably this is one definition of the word complex.

Driving the idea further, Tiho Brkan tweeted a chart showing the increased use of "illiquid asset and private deals" in sophisticated pools of capital as the simplest exposure to broad domestic equities has been the top performer, no doubt believing that because it is more complex, it must be better.

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