Improving Your Investments With a Kiss: Keep It Simple
Legendary Investors Warren Buffett and Peter Lynch on Simplicity
Of all of the investment advice you are likely to receive in your lifetime, some of the best is, "Keep it simple, stupid!" or Kiss. The concept behind this deceptively dismissive phrase gained popularity from two sources. The first was Peter Lynch at Fidelity, one of the greatest equity investors in history. He was fond of telling people to "buy a business so simple even an idiot could run it because sooner or later, one will" and "invest in what you know". He also advocated investors pay attention to what they were spending to acquire ownership of assets relative to growth and earnings focusing on the PEG and dividend-adjusted PEG ratios. The second was Warren Buffett, the legendary Chairman and CEO of Berkshire Hathaway, a diversified holding company engaged in nearly every sector and industry of the economy.
When you take the "Keep it simple, stupid" approach to your investments, applying it at both the overall portfolio management and individual security levels, you focus on the handful of things that really matter and can significantly decrease the risks to which you expose your precious and often hard-earned wealth. It allows you to see past the noise, obfuscation, and focus on owner earnings, among other relevant facts. It avoids complexity which, anyone with an engineering or probability background can appreciate as each additional breakpoint introduced, no matter how small the individual chance of failure, significantly increases the chances of failure on the whole. That's the last thing you want when running a portfolio of irreplaceable capital upon which you, your family, or a person or institution to whom you owe a fiduciary duty relies for passive income such as dividends, interest, and rents.
(For those of you who aren't familiar with probability theory, a quick illustration might help. Which would you rather have: a stock that has a 65% chance of doubling in the next five years or a stock that has a chance of quadrupling if eight different events all take place (perhaps a business license in a new state, a new factory built, etc.), each event having a 90% probable success rate? The latter, believe it or not, has an approximate 43% chance of coming true – much worse odds than the former option. With more links in a chain, you have greater odds of something going wrong. If a stock could go up 1,000% but for it to do so, the labor unions must drop demand, fuel supplies must collapse, a bankruptcy court must force a competitor to pay its promised pension obligations, and new management to come in and cut stock option expenses, you are probably going to be disappointed at best or, at worst, end up like these poor people.)
Use the One-Paragraph Test
With the exception of certain strategic investments from a business management that are beyond the scope of our discussion, every investment you make in life presumably comes down to the hope that you will grow the money you commit into more purchasing power so you can do more; buy more cars, houses, vacations, give more to charity, leave more to your children or grandchildren. Investments generate their intrinsic value from the cash flows they produce, either internally or from conversion activity. That's not all. The price you pay relative to those cash flows ultimately casts the die as to what you can expect in terms of compound annual rate of return. If you pay 2x for $1 of net present value adjusted for taxes and inflation, you will earn half the rate of return you would have had you paid 1x. It's that simple.
When you understand this fundamental truth you see the wisdom in the behavior of Peter Lynch and Warren Buffett in that they demand to know, specifically and quickly, the reasons you think an asset is attractive. Peter Lynch reportedly used to start an egg timer when on the telephone with financial analysts and traders. He told them they had less than one minute to explain the basic premise of an investing idea. Warren Buffett recommends that you write out a short paragraph expounding something along the lines of, “I am buying $10,000 shares of Company XYZ at $25 per share because I believe (insert reason here such as profit will grow twice as fast as the current price-to-earnings ratio, hidden assets are on the balance sheet, there was a management change for the better, valuation is too low, etc.) Then, monitor the situation, always mindful of your basic thesis. It's related to the concept of highly productive people; how you can't actually bake a pie. You focus on making sure each ingredient, and each step, is correct and the pie happens by itself, manifesting as you get the inputs right. If you buy shares of a company and expect earnings to grow at 12%, only several years later, they're compounding at 8%, you know something is wrong or different. Pay attention to that. Don't waive it off and forget about the justification for making the investment in the first place.
Only Hold Securities Through Cash Accounts, Paid in Full, and Stop Trying to Be So Clever
One of the biggest mistakes we see investors make is they get into this weird behavior pattern where they try to use their portfolio to make them feel intelligent or special somehow rather than focusing on what matters - cash flows. When it comes to investing in stocks, your job is to buy profits.
This need for complexity is endless, coming and going in cycles that often result in catastrophe. There was portfolio insurance in the 1980s. There were leveraged Asian exposures in the 1990s. There were collateralized debt obligations in the 2000s. Now, the newest thing people are trying to get to catch on are Robo-Advisors; automated software platforms are written with unknown proprietary algorithms to which people are entrusting their entire net worth in a game that reminds me of a toddler playing with a loaded gun. The other day, for pure entertainment, we created a profile for a hypothetical 50-something-year-old investor with $250,000 in income and almost no retirement savings to see what one of the biggest Robo-Advisors, one that builds portfolios out of low-cost ETFs, recommended. When the securities list was returned, we dug down into the underlying holdings - the actual investments lurking below the surface, unseen by most owners of these asset pools - and found that a not-insignificant sum of money was being placed in what are effectively highly speculative sovereign debt of countries that are less than beacons of transparency and stability. This is asinine. It's efficient market nonsense run amok; a case of people convinced they can diversify away dumb exposures by adding even more dumb exposures. An investor who wanted a fixed income component should have been perfectly content to buy five-year FDIC-backed certificates of deposit for 2.15% or whatever they happen to be yielding at the moment. Instead, the software decided to "reach for yield", one of the most foolish things an investor can do and that leads to more losses than almost any other force in the debt markets. For heaven's sake, only a few years ago people weren't content to sit on cash so they tried to eke out a bit of extra return by buying auction-rate securities only to find they were broke when liquidity dried up in the 2007-2009 collapse. Why live like that? It is so unnecessary. Stop making your life harder than it needs to be. Stop sabotaging yourself.
If you want to hold investments, and you don't have any special needs, be content to a diversified mix of stocks and bonds - and yes, if you are over a certain age, you probably need both as stocks and bonds play different roles in your portfolio beyond their nominal returns. Hold these assets in a cash account, not a margin account, to avoid rehypothecation risk, even if it means, for some investors in some situations, paying nominal custodial fees. Sit back and collect your dividends and interest income. Think of your portfolio as a way to inventory profits from your core economic engine, which, for most people, is their career, and stop trying to get rich from it overnight. If you don't know what you are doing, or aren't working with an asset management company for the wealthy, consider investing in index funds which are probably your best bet until you reach a certain level of net worth after which point they become foolish for a myriad of reasons including methodology shortcomings and potential tax exposures.
More Ways to "Keep It Simple, Stupid!"
There are all sorts of other ways you can follow the "Keep It Simple, Stupid!" philosophy. Some investors only acquire investments in round-lots of 100 shares so their portfolio accounting is easier. Some high net worth investors find a registered investment advisor working on an open architecture platform so no matter how many different holdings they have, or how many different asset managers they hire, it's all reported in a central, consolidated place and, maybe, even in a central, consolidated custody account. How to implement the practice into your own life will depend on your personality and unique circumstances, needs, and preferences. The point is to embrace the fact that simplicity is beautiful. Simplicity can protect you by making it much clearer what risks you are taking. Simplicity also makes your life easier.