Investing By Subtraction

"What does you in is not failure to apply some high level, intricate, complicated technique. It’s overlooking the basics. Not keeping your eye on the ball.”1 - Eliezer Yudkowsky

When investors must confront unexpected problems, their first reaction is to consider new investments, strategies, or funds to deal with the pressing issues. The typical assumption is that something must be missing and by finding that magical investment addition, the new portfolio will be once again be fortified against future problems.

This thought process leads to big problems. Portfolio performance is often handicapped by adding new investments. It’s a human flaw to think that every problem is solved by adding something. It’s often found in medicine (if you are sick add medication), regulation (if there is a problem, add more laws), education (if student outcomes are poor add more testing and requirements).

“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”       - Charlie Munger

People fail to consider that problem removal should be the first solution. Investment failures often originate from within! Portfolios often improve by subtractinginvestments, funds, or strategies, not by adding them. Investor allocations have become so heavy with funds layered upon funds, even a sophisticated investor is powerless to make intelligent decisions. Complexity is not sophisticated, simplification is sophisticated.

Less is more: paradox of choice. Large selection leads to inner paralysis. The more choice you have, the more unsure and therefore dissatisfied you are afterward. In this age of unlimited variety, good enough is the new optimum. Learn to love a good choice. – Rolf Dobelli, The Art of Thinking Clearly

The Art of Investing is Knowing What to Remove

Because investors have been taught that it’s useless to think about investment fundamentals and price vs. value, they resort to a shotgun approach of funds and strategies. They succumb to the myth that owning a cluster of random products is diversified and that alone will protect themselves against bad outcomes. Unfortunately, this assumption fails in most instances.

“Sophisticated or complex methods do not necessarily provide more accurate forecasts than simpler ones.”2 – Robin Hogarth

High Correlations

Investors fail to realize their exposure to tight correlations. Most portfolios have tremendous overlap in crowded trades because investors choose to be willfully ignorant of the investments they own.

Labels and Categories are Misleading

Investors rely on superficial categories that fail to explain true exposures. A European company may have 80% of its sales and profits from outside the Eurozone, yet it would be considered 100% European exposure. It’s a common shortcut among investors and advisors because they are too lazy to examine the underlying investments. Labels such as low-risk, liquid, and stable are widely used but often fail to reflect the underlying risks.

Lack of Insight and Understanding

Finally, when a crisis or financial panic ensues, investors have no idea what kind of quality they own. Or know good managers vs. bad managers. Or what investments are undervalued vs. going to zero. And so on…

In this age of information abundance and overload, those who get ahead will be the folks who figure out what to leave out, so they can concentrate on what’sreally important to them. Nothing is more paralyzing than the idea of limitless possibilities. The idea that you can do anything is absolutely terrifying.”- Austin Kleon, Steal Like an Artist

Investors fool themselves into a false sense of comfort during calm times, only to be exposed and their confidence decimated when the markets get ugly. By reducing investment complexity down to a manageable level, investors will actually understand their true risk exposures. In a world of multi-tasking and unnecessary complexity, simplification is often the antidote to excessive choice and complications. Investors have been taught that diversification works, while making no distinction between the triumph of intelligent diversification and the failure of mindless diversification.