By Jack Forehand (@practicalquant)
Successful investing can be complicated. And our natural inclination as human beings is to want to address complicated problems with complicated solutions. But that can be to our detriment at times. Jim O’Shaughnessy wrote an excellent tweetstorm on Twitter this week on the benefits of simplicity and it got me thinking about how difficult the balance between simple and complex can be in investing.
From what I have seen in my career running factor-based models, simple is usually best. Our tendency as human beings to make things more complex than they need to be tends to do more harm than good, and leads us to seek complex solutions when simple ones would do just fine. But investing is a complex game and just using the simplest solution to any problem can also be problematic.
So what is the answer? As is the case with many decisions in investing, it isn’t completely clear cut. My goal has always been to try to find the simplest solution possible to any given problem, understanding that sometimes that solution will be more complex than I would like it to be.
The best way to see how this balance plays out in the real world might be to look at some examples.
Is Simple Value Investing Dead?
If you look at the academic research that provides long-term support for value investing, it is actually very simple. When Fama and French defined value in their 3-factor and 5-factor models, they only used one variable. They found that using the Price/Book ratio to identify value stocks resulted in excess return over long periods of time. Significant academic research since then has verified that conclusion.
So if I wanted to use the most simple approach to value possible, I might just use a one variable strategy where I select a basket of stocks that are cheapest using the Price/Book. Or I could replace the Price/Book with a different simple value variable like the PE ratio or the Price/Sales.
But is that very simple approach the best way to build a value-based portfolio? A look at the historical base rates would say that the odds of that simple system beating a market cap weighted index over long periods of time are actually quite good. Some basic adjustments to it can make it significantly better, though. The first issue with that strategy is that it is very hard to pick the one value metric that will work best going forward. The Price/Book ratio has been the most maligned ratio is recent years (and rightfully so since intangible assets comprise the majority of assets these days, but are not included in the Price/Book), but all the individual ratios have their own unique issues. It might be better to just use a composite of all of them. That way I eliminate the risk of picking the wrong ratio and my return will be the average of all the major value metrics.
Another issue that I might want to address with my basic value strategy is the fact that many cheap stocks are cheap for a reason. I wrote an article a while back where I proposed one method that might help to do that, so I won’t discuss all the detail here. But in general I think the evidence supports the conclusion that you can improve the returns of a value strategy by eliminating low quality stocks.
With these two changes I have made to my value strategy, I have now improved the likelihood of its success. But I also have added complexity. I could easily use these same types of arguments over and over to continue to add complexity to my strategy and the whole process could quickly get out of control. That is why the battle between simple and complex is so difficult. On one hand, my original simple strategy with one variable was not optimal. But on the other I need to be careful not to add complexity just for the sake of doing so without actually improving the strategy. I think my two proposed changes above struck a good balance between the two fairly well, but the right answer can be very difficult to find.
Simple vs Complex in Trend Following
Trend following is another good example of the battle between simple and complex in investing. At its core, trend following is very simple. Pick something like the 200-day moving average, stay invested when the market is above it, and sell your stocks or hedge when it is below. It doesn’t get much simpler than that.
But like many things in investing, the devil is in the details. There are two major decisions you need to make with trend following. The first is which trend indicator you use. The second is how often you apply it. Many funds use a simple 200 day moving average system like I described above and make adjustments once per month. If the market is below the 200 day moving average at the end of the month, they will remain in cash or hedged for the following month. Over the long-term, that simple system works out just fine, but in individual instances, it can get things very wrong. All trend following systems will have false signals, so that isn’t uncommon, but by only using one indicator and only applying it once a month, that type of strategy ends up taking a good amount of unnecessary risk. If the market ends up slightly below the 200-day moving average at the end of any given month and then sharply reverses, this type of simple system will have to wait a month to get back in, which can lead to major negative deviations from the market’s return. What has happened this year is a good example of how using month-end indicators can hurt you as many simple trend systems stayed out of the market from the beginning of the year until the end of February and missed most of the market rally.
A more complex trend following system can address this problem in two ways. First, it can use multiple signals and couple the 200-day moving average with other indicators. That way if the 200 day moving average ends up being the worst indicator in a specific decline, the other indicators can pick it up. The second is applying the signal more than once a month. A system applied weekly or even daily is less prone to bad timing luck.
Over really long periods of time, the simple and more complex system will likely have close to the same performance. But the more complex one is less likely to have a major negative event due to bad luck, which means investors are much more likely to stick with it.
Simple, But Not Too Simple
Simple often beats complex in investing for good reason. Our overconfidence as investors leads us to want to continue adding layers of complexity to our portfolios, and that often leads to an inferior result compared to what a much simpler system would have generated. Even with the modifications I made, the trend following and value strategies I discussed are still fairly simple. But they do add some complexity relative to the simplest option.
In the end, finding the perfect balance between simple and complex is very difficult, and the right answer may vary for each person. But if you can err on the side of simple and make sure any complexities you add beyond that are clearly superior to the simple option, you will likely end up with a strategy that strikes the right balance and gives you the best chance of achieving your investing goals.
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