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In Praise of Simplicity

All too often, clients come to me with investment ideas they like. Some are good and some are not so good, but many of them are complex. As humans, we are often seduced by complexity, as though the more glamorous or intricate an investment instrument is, the better it must be. Why own a set of simple and low cost index funds when you can buy a hedge fund? Why buy and hold when you can trade actively? Is the market falling? Why not short some stocks?! Just think of the possibilities!

Now a dose of reality. This type of behavior is part of the reason that “the average investor” underperforms the market over time. Please allow me, in an effort to save you from yourself, to make an impassioned argument for the cheap, simple, and boring.

Digging Out of the Fee Hole

Complexity often comes with a cost in the form of higher fees.[1] A money manager who actively trades your account is likely to charge a higher fee than a money manager who updates investments once a quarter or semi-annually. Actively managed Mutual Funds generally have higher internal expenses than passively managed Funds[2] (index funds). Investments like hedge funds and private equity funds come with yet higher fees. These higher fees may be largely mitigated if your chosen investment does well by providing an above market return.

But incurring higher fees than necessary puts you in what I like to call a “fee hole.” That’s the hole you need to dig yourself out of before you can start earning a positive return. The bigger the hole, the more you need to outperform to dig out (more on outperforming later).

Would you rather dig yourself out of a 3% hole or a 1.5% hole?

I Didn’t Think It Would Turn Out Like This

If it’s complex, exotic, or hot, it’s also likely to be high-risk. I wrote all about risk and risk tolerance back in May. If it’s high-risk, you could be opening yourself up to losses you can’t tolerate. As an example, I often have clients ask me about buying into companies that have an upcoming Initial Public Offering (IPO). Being curious about IPOs is natural enough — the stock is in the news, investors seem excited, and the return potential looks so attractive. Why not get in on it? Because IPOs can be very risky. There isn’t as much public information about the company (compared to companies that have been trading publicly for a long time), and there may be news that hasn’t yet broken that could affect the company’s stock price a great deal. In addition, the IPO may simply be overhyped, which can happen in the weeks and days leading up to the first day of trading.

Some investors, in their lust for the new and exciting, fail to properly gauge the risks involved. If and when things go wrong and the value of the investment drops more than expected, the natural reaction will often be to sell to stop the pain. Once an investment is sold, those losses are locked in — you will have damaged your returns in a very meaningful way.

Don’t Just Stand There, Do Something!

Our brains are set up to value action over inaction. It’s just how we are wired. Naturally, we want to think that the money managers we hire (either as Financial Advisors or Mutual Fund Managers) are hard at work each day looking for angles and opportunities to squeeze every last ounce of return out of the market. It feels good to think that someone is on the job doing something.

Here's the problem: markets are efficient — meaning that everything the public knows is already included in the price of a given asset. There are very few angles to exploit. It’s simply too hard to outsmart the market consistently over time.

Doing the (Nearly) Impossible

Don’t pay someone good money to do the (nearly) impossible.[3] The dirty little secret that many money managers don’t want to fess up to is that “beating the market” consistently is nearly impossible. A manager might beat the market for one year, two years, or even three years. But that same manager will then tend to underperform in future years. Why? As I said above: the market is efficient, and there are very few angles left to work that would result in outperformance[4] on a consistent basis.

That’s not to say that active management has no place. There are situations and circumstances where active management is appropriate and necessary. But those situations are often limited, and for most investors a core portfolio of passively managed investments is appropriate.

What Does Work

Cheap, simple, boring — these are the elements of a good investment portfolio. Cheap, because you want to limit the depth of that fee hole you need to dig out of. Simple, because if you understand it, you’re less likely to get nasty surprises that cause you to bail when things go wrong. Boring, because the exiting and novel usually come with more risk, which likely isn’t appropriate for your long-term goals.

I know you were hoping that the magic formula would add more sizzle to your portfolio (or in fact be magical). And now you’re wondering why anyone needs a Financial Advisor if cheap, simple, and boring is the way to go. It’s a valid question.

Not every investor needs a Financial Advisor at every stage of their lives. Those who do need an advisor typically share some or all of these traits:

  • They don’t feel confident in their ability to select investments
  • They don’t have the time to run their own investment portfolios
  • They know that they need the steady hand of a Financial Advisor during rough markets
  • They feel the need for and value the process of Financial Planning

If any of this sounds like you, engaging the services of a Financial Advisor to help you simplify and rationalize your plan and investments might be the right move for you.

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[1] In this context, I am describing a product with higher fees associated with the complexity of the vehicle. For example, the typical index fund has internal expenses of 0.8%or lower while a typical hedge fund has internal expenses starting at 2%.

[2] Sometimes also called Exchange Traded Funds (ETFs)

[3] This doesn’t mean you shouldn’t have a well-thought-out strategy that you implement long term. But your goal simply can’t be to “beat the market;” you’ll be setting yourself up for failure.

[4] Outperformance being returns that are greater than the benchmark index or expectations.