I Flirted With Complexity. Here’s What She Taught Me

crispydoc Uncategorized 6 Comments

It was late at night when the bartender called last round. She was wearing a sophisticated little black dress, seated alone at a small table, when our eyes met across the room. Full of liquid courage, I made my way over, asked what she was drinking, and ordered two.

I'd heard rumors about her before in the books I was devouring at the time - books about factor investing, sector diversification, various models of "lazy" portfolios on the Bogleheads Forum.

By the end of our drink together, my gait was tilting like a Fama and French portfolio as she used her wile to seduce me. Her name was Complexity, and although I found her charming, I soon realized our long-term vision was not aligned.

I Enjoy DIY Investing

Every Do-It-Yourself investor has at one time considered a highly optimized, exceedingly complex portfolio that takes into account regional geopolitics, lunar phases, commodity prices and butter production in Bangladesh.

When you first drink from the hydrant of financial literacy, there is a compulsion to put every bit of what you learn to bear in your personal  portfolio all at once.

It's why newbie investors who have been paying financial advisors 1% of assets under management fall madly for robo-advisors. They are beside themselves at being able to diversify so cheaply, and they can barely hide their enthusiasm for tax-loss harvesting done using primarily low-cost, passively managed index funds.

It Turns Out I also Value Simplicity

These same investors eventually find themselves transferring their assets out of robo-advisors and into frugal brokerage favorites like Vanguard, Fidelity and Schwab several years later.

As Rick Ferri put it on a recent WCI Podcast interview,

"There is no such thing as the perfect portfolio...You’re going to keep on adding things, taking things out, trying to find the ideal mix, trying to find negatively correlated asset classes...what works is a simple portfolio, something like the three-fund portfolio.”

Gasem (among other physician finance bloggers) has made a convincing case that the three fund portfolio has clear shortcomings, and is the purported diversification benefit of adding international equity is not built on sound math. He has suggested a two fund portfolio would do better, and provided evidence to that effect.

Does this clash of the investing titans mean Rick Ferri is dead wrong? I'd suggest Rick has realized that there's value in a good enough portfolio.

Just as adding the nth stock to a well-diversified basket of equities will not significantly reduce your risk beyond a certain point, it turns out that adding complexity to a good-enough portfolio leads to marginal return on time invested.

Will Gasem's two fund outperform the Bogleheads' three fund portfolio with greater return and less risk over time? I'll leave it to the reader to weigh the evidence.

What Is Your Time Worth?

The root question you should be asking is whether the time you spend on that final optimization is worth spending on your portfolio, since the additional time required to rebalance a finely sliced and diced portfolio is time that might have gone to other (higher?) purposes.

Did it make you late for date night?

Did it prevent you from a flying a kite with your kid?

Did it bleed into that hour you'd allotted for daily fitness?

Did it somehow prevent you from connecting with friends or reaching out to family?

For the hobbyist who enjoys portfolio management, by all means, continue managing a portfolio with complexity (although I'd advise you to have a clear plan B in place if something should happen to you such that your spouse or next of kin can manage the complex portfolio they inherit).

For the average Joe, there's truth in Jack Bogle's perspective on "the majesty of simplicity."

It's Not You, It's Me

After a brief and heady romance, I ended my relationship with Complexity. She was alluring, and she was seductive, but she was no match for her archrival, Simplicity.

Complexity wanted all of my time and attention. Complexity was in perpetual crisis, full of drama.

Simplicity was willing to make a long-term commitment. Simplicity did not feel threatened by allowing me to pursue other interests and friendships. Simplicity felt secure.

I ended my relationship with Complexity. Let her down with, It's not you, it's me.

Simplicity and I have never looked back.

Comments 6

  1. I know complexity intimately and have lost money to her. Complexity eats your lunch. The problem is added complexity is measured on the margin and therefore all complexity is not equal not by a long shot.

    I envision a portfolio like a wagon wheel with spokes. There are 4 main dimensions up down right left. That starts to define a volume, a plane if you will. Complexity adds more spokes and starts to round the square plane into a circle. The area of a circle is more efficient than the area of a square so those few more spokes scattered equally around the perimeter turns the square into a wheel. The relationship between spokes is a factor called correlation, a critical factor when it comes to diversity. Correlation determines the roundness of the wheel. Risk also determines roundness. Risk is the length of the spoke. Big risk distorted wheel.

    So lets say you buy a complicated 3 fund. The correlation between foreign and U S is about .84 and between US and EM is .77 That means for the most part those 3 spokes pretty much all go in the same direction and don’t round out the wheel much. The risk of global (spoke length) is more than US and the risk of EM hugely more so you get a little diversity between these but the risk further distorts the perimeter. When the crash comes all three of these spokes strongly retreat to the center and the 2 spokes with more risk retreat even faster. So the “diversity” you gained on the way up dissolves on the way down to something worse than if you just owned US from the start.

    Lets add Bonds. Bonds have a 0 correlation with stocks. That means if the US spoke is vertical the bond spoke is horizontal, and it stays virtually constant in a crash. It hold up its end of the bargain giving you a bigger more round wheel but it doesn’t grow so much compared to US stocks but then it doesn’t shrink in a crash either. This picture explains the relative importance of asset class. A nod is as good as a wink to a dead horse and global is actually worse than US in a crash and EM is a disaster. If US drops 50%, em DROPS 75% takes a long damn time to recover a 75% loss especially when the return of EM is 2/3 the return of US. BAD JUJU

    The way you help bonds along is you re-balance. Since bonds grow more slowly than stocks you cut a little off the stock spoke and graft it onto the bond spoke on the way up. When the crash comes you can take some of that grafted value and return it back to the US stock helping o keep the wheel round. Since the bonds remain stable with a 0 correlation that graft is there preserved to be returned when needed. So a 0 correlation (what is called non correlated) is far MORE NECESSARY to a portfolio’s survival in the bad times. EM or Global (highly correlated) is a hindrance in bad times. You get a little dab of diversity on the way up and a nightmare on the way down. I’ll skip the nightmare thank you very much ans sleep soundly.

    Understanding the efficient frontier plane is the actual quantitative mathematical representation of the wheel. The tangent portfolio is roundest. Other portfolios along the line are less round but you may choose for their excess return for a given risk. Portfolios not on the line are IMHO the nightmare portfolios and who wants to own a nightmare? You can own a nightmare because you think it makes you look smart, but on the plane where it matters you’re a dope. Homey says DON’T BE A DOPE!

    What could be simpler than a 2 fund re-balanced occasionally on the way up and definitely re-balanced in a crash? Parsimony of risk management at its finest.

    Who’s gonna win? Depends on the goal. If the goal is to run out of breath before you run out of money my scenario wins. If the goal is to die with the most money some other scenario like 100% stocks over a very long period may win. The problem is with that scenario the probability of running out of money before breath goes up dramatically.

    Balls in your court.

    1. Also the knock on AUM is misunderstood and a straw man. Certainly there are AUM like Raymond James or insurance salesmen who are ripoff. But my AUM charges about .3% on my portfolio. For that .3% I get tax loss harvesting, a readout on what’s the most efficient things to sell from a tax perspective and access to low cost institutional grade which have slightly more efficient trading rules than their commercial counter parts. It greatly improves and granularizes my decision making. On a 5M portfolio my AUM charges 15K/yr but over time the improved efficiency in my portfolio may be 50K/yr so the real calc is not that 1% multiplied nonsense but 50K – 15K or 35K/yr positive cash flow.

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        The AUM may be well worth it, although I suspect that value increases significantly when tax-efficient withdrawal (a delicate dance) requires considerations beyond most mere mortals, or at the very least benefits from a second set of eyes. The access to institutional instruments and improved cash flow are a legitimate alternate perspective. TLH can be simplified by bundling reinvestment of dividends so one can pore over quarterly rather than weekly lots to accumulate the paper losses, so I’m less convinced that the benefit is significant enough to warrant the cost.

        I suspect you can build a nest egg handily without an AUM advisor (using a fee only/hourly advisor as a second set of eyes to review the plan PRN), but obtaining the input when you deplete that nest egg may be far more valuable since the steps to the tax dance are constantly changing.

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      This is a dense and chewy one and I don’t know where to begin except to express gratitude. The wheel and spoke analogy fits perfectly. The point that all complexity is not equivalent is well taken. I enjoy communion at the temple of parsimony over which you preside. I’d conclude from your observations that not only age but humility results in increased bond allocation over time.

  2. “Simplicity has a way of improving performance through enabling us to better understand what we are doing.” – Charlie Munger

    Investing should be boring. Save the excitement for late nights and little black dresses 🙂

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