Barry Ritholtz at The Big Picture has some musings about portfolios for the New Year. I think he’s right about keeping it simple—but I also think his thought is incomplete. He writes:
May I suggest taking control of your portfolio as a worthwhile goal this year?
I have been thinking about this for awhile now. Last year (heh), I read a quote I really liked from Tadas Viskanta of Abnormal Returns. He was discussing the disadvantages of complexity when creating an investment plan:
“A simple, albeit less than optimal, investment strategy that is easily followed trumps one that will abandoned at the first sign of under-performance.”
I am always mindful that brilliant, complex strategies more often than not fail. Why? A simple inability of the Humans running them to stay with them whenever there are rising fear levels (typically manifested as higher volatility and occasional drawdowns).
Let me state this more simply: Any strategy that fails to recognize the psychological foibles and quirks of its users has a much higher probability of failure than one that anticipates and adjusts for that psychology.
Let me just say that there is a lot of merit to keeping things simple. It’s absolutely true that complex things break more easily than simple things, whether you’re talking about kid’s Christmas toys or investor portfolios. I believe in simplicity over complexity.
However, complexity is only the tip of the iceberg that is human nature. Mr. Ritholtz hints at it when he mentions human inability to stay with a strategy when fear comes into the picture. That is really the core issue, not complexity. Adjust for foibles all you want; many investors will still find a way to express their quirks. You can have an obscenely simple strategy, but most investors will still be unable to stay with it when they are fearful.
Trust me, human nature can foil any strategy.
Perhaps a simple strategy will be more resilient than a complex one, but I think it’s most important to work on our resilience as investors.
Tuning out news and pundits is a good start. Delving deeply into the philosophy and inner workings of your chosen strategy is critical too. Understand when it will do well and when it will do poorly. The better you understand your return factor, whether it is relative strength, value, or something else, the less likely you are to abandon it at the wrong time. Consider tying yourself to the mast like Ulysses—make it difficult or inconvenient to make portfolio strategy changes. Maybe use an outside manager in Borneo that you can only contact once per year by mail. I tell clients just to read the sports pages and skip the financial section. (What could be more compelling soap opera than the Jet’s season?) Whether you choose distraction, inconvenience, or steely resolve as your method, the goal is to prevent volatility and the attendant fear it causes from getting you to change course.
The best gift an investor has is self-discipline. As one of our senior portfolio managers likes to point out, “To the disciplined go the spoils.”