User:Quebec/Simplicity versus complexity

In portfolio construction and investment management, investors are often torn between simplicity and complexity. In can be tempting to increase the complexity of portfolios by:

• Increasing the number asset classes
• Splitting asset classes into sub-classes
• Tilting the portfolio towards value stocks, small stocks, or low-volatility ones
• Engaging in tactical asset allocation or sector rotation
• Using multiple managers or strategies per asset class
• Trying DIY stock picking to beat the market, or pick a promising actively managed mutual fund or hedge fund
• Exploring fashionable ideas like smart beta, or risk parity
• Etc.

Some of these strategies may produce increased returns for some investors. But for many investors, complexity can lead to higher fees, more turnover, more taxes, and potentially counterproductive behaviour. It can be tempting to change one’s asset allocation, frequently trade or change strategies with a complex portfolio.

Simple portfolios

The more complex the world around us becomes, the more simplicity we must seek in order to realize our financial goals. Please underrate neither the majesty of simplicity nor its proven effectiveness as a long-term strategy for productive investing. Simplicity is the master key to financial success.

— John Bogle

Simple does not mean simplistic or unsophisticated, and does not mean missing out on good returns. Portfolios composed of three to five index funds or index ETFs are simple to set up and rebalance, and widely diversified. For example, the three ETF portfolio has:

• Exposure to over 500 Canadian bonds (terms of 1 to over 25 years; credit ratings covering the full investment grade spectrum, include government and corporate bonds)
• Exposure to nearly 250 Canadian stocks covering large-, mid- and small-capitalizations
• Exposure to thousands of large- and mid-capitalization stocks from other developed and emerging markets

These simple index portfolios require no monitoring whatsoever, almost no ongoing work (e.g., rebalancing once per year), no external advice (think fees), and yet are likely to outperform most actively managed portfolios with the same asset allocations because of low MERs, low transaction fees, and low turnover. Because of the simplicity of the portfolio and its passive management, the investor’s urge to tinker should be suppressed more easily. There should be fewer behavioural issues (the whole process can be automated to take emotion out of equation) and the portfolio should be fully invested all the time, so it won’t miss on any gains.

Why it's difficult to keep it simple

Why do we distrust such simple solutions? Carl Richards, a US financial planner, writes that "we’re attracted to complexity because anything that requires a lot of something – time, details, money – should work, right? By default, if it’s simple, say only two steps instead of ten, we think we’re missing out." Another way to say this is that "our investing brain seems hard-wired to resist straightforward solutions".

Complex solutions promise market beating returns, and it is difficult to 'settle' for a portfolio that can never beat the market:

"It’s hard to let go of the dream. Carlson quotes Benjamin Graham, who said, “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” One of the most difficult obstacles investors face is the nagging feeling that there’s something better out there. Market returns can now be had for less than 10 basis points, and these are almost certainly enough to allow investors to reach any realistic financial goal. Yet we sabotage ourselves by rejecting an easy A-minus and instead wind up with a C or D. “It’s amazing how easy it is to do worse by trying to do better.”"

According to Jason Hsu and John West, complex, high-turnover strategies can be used by managers or agents to justify higher fees, but may have lower returns than simple strategies after fees and taxes. They also add 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."

Active versus passive management

Scomac, a long-time Financial Wisdom Forum member, has experience with both active and passive management. He writes that:

"Many folks gravitate naturally to best practices methodology. For those folks, index investing is a natural fit. They're looking for a how to method that is well proven to be successful. They will tend to use that sort of approach in other areas of life beyond investing whatever the activity may be. For the rest of us, there are a whole host of reasons why we might chose to invest in a different manner. We're taught to be competitive. It's the way of the world and yet index investing, at least at first blush, appears to be contrary to that notion. It's a difficult thing to reconcile and usually one goes through a journey of sorts to get to that point. Sometimes the School of Hard Knocks is the only teacher."

When complexity can be desirable

• Adding additional asset classes can provide further diversification, protection against inflation, or safe haven properties (RRBs, REITs, gold, cash, foreign bonds, EM stocks, ...)
• A five year GIC ladder yields more than a short term bond ETF with a comparable average maturity
• Indexing (with funds or ETFs based on total market indexes) works fine for many asset classes, but Canadian Equities are somewhat of an issue. Alternatives can be more complex, but may be needed for investors with large allocations to this asset class
• Tilting to value or small stocks, or low-volatility stocks, may increase returns if the anomalies persist
• Portfolio immunization or liability matching
• ...