There are at least eight reasons why taking a simple approach to investing is a wise thing to do.
- Reduced “Too smart for you own good risk”
- Clearer risk management
- Less trading
- Taxes are likely easier
- Not Trendy
You have to understand your investments, even if it’s just at the highest overview level. If you don’t have that level of understanding, then at some point you will be tempted to change your investments during a period of market duress, and it will likely be a mistake. Panic never pays. How to avoid panic? Knowledge reduces panic. Whatever the strategy is, follow it in good times and bad. Understand how bad things can get before you start an investment program. Make changes if needed when things are calm, not in the midst of terror.
You should be able to explain your investment strategy at a basic level, enough that you can convey it to a friend of equal intelligence. Only then will you know that you truly understand it. Also, in trying to explain it you will discover whether your investments are truly simple or not. Does your friend get it, even if he may not want to imitate what you are doing?
Take an index card and write out the strategy in outline form. Would you feel confident talking for one minute about it from the outline?
Reduced “Too smart for your own good risk”
If you have simple investments, you will tend not to get unexpected surprises. One reason the rating agencies did so badly in the last crisis was that they were forced to rate stuff for which they did not have good models. The complexity level was too high, but the regulators required ratings for assets held by banks and insurers, and so the rating agencies did it, earning money for it, but also at significant reputational risk.
Why did the investment banks get into trouble during the financial crisis? They didn’t keep things simple. They held a wide variety of complex, illiquid investments on their balance sheets, financed with short-term lending. When there was doubt about the value of those assets, their lenders refused to roll over their debts, and so they foundered, and most died, or were forced into mergers.
I try to keep things simple. Stocks that possess a margin of safety and high quality bonds are good investments. Stocks have enough risk, and high quality bonds are one of the few assets that truly diversify, along with cash. That makes sense from a structural standpoint, because fixed claims on future cash are different than participating in current profits, and the change in expectations for future profits.
Clearer risk management
When assets are relatively simple, risk management gets simple as well. Assets should succeed for the reasons that you thought they would in advance of purchase. Risk assets should primarily generate capital gains over a full market cycle. fixed Income assets help provide a floor, and limit downside, so long as inflation remains in check.
With simple asset allocations, you don’t tend to get negative surprises. Does an income portfolio fall apart when the stock market does? It probably was not high quality enough. Does you asset allocation give large negative surprises close to retirement? Maybe there were too many risk assets in the portfolio after a long bull run.
Cash and commodities (in small amounts) can help as well. Those don’t have yield, and don’t typically provide capital gains, but they would help if inflation returned.
Simplicity in asset allocation means you can sleep at night. You’ve already determined how much you are willing to lose over the bear portion of a market cycle, so you aren’t looking to complicate your life through trying to time the market. Few people have the disposition to sell near near top, and few have the disposition to buy near near the bottom. Almost no one can do both. (I’m better at bottoms…)
Pick a day of the year — maybe use your half-birthday (as some of my kids would say — it is six months after your birthday). Look at your portfolio, and adjust back to target percentages, if you need to do that. Then put the portfolio away. If you have set your asset allocation conservatively, you won’t feel the need to make radical changes, and over time, your assets should grow at a reasonable rate. Remember, the more conservative asset allocation that you can live with permanently is far better than the less conservative one that you will panic over at the wrong time.
Taxes are likely easier
Not that many people have taxable accounts, though half the assets that I manage are taxable, but if you don’t trade a lot, taxes from your accounts are relatively easy. Unrealized capital gains compound untaxed over time, and there is the option to donate appreciated stock if you want to get a write-off and eliminate taxes at the same time.
You won’t get caught in fads that eventually blow up if you keep things simple. You may be pleasantly surprised that you buy low more frequently than your trendy neighbors. Remember, people always brag about their wins, but they never tell you about the losses, particularly the worst ones. Those who don’t lose much, and take moderate risks typically win in the end.
Simple investment strategies tend to have lower management fees, and fewer “soft” costs because they don’t trade as much. That can be a help over the long run.
That’s all for this piece. For most investors, simplicity pays off — it is that simple.