Ockham’s razor is a logical principal that essentially states that simpler solutions are more likely to be correct than complex ones. William Ockham lived throughout the 13th and 14th centuries, and the origination of this idea can be traced back even further. In a world in which information is delivered like an avalanche, his principle holds true today with renewed influence.
It is difficult, however, to not be drawn into the allure of a well-organized presentation full of beautiful graphics, trend lines, and deep mathematical analysis. It is incredible how effective these marketing documents are in portraying sophistication. Looking beyond this facade reveals a very simple truth: That this does not contribute to the success of my financial life.
The Past
The truth is that we are provided with so much information that it has become an exhausting exercise just to determine what is relevant. Is the time and effort worth the results? Does having this much information actually improve the accuracy of prediction?
The short answer is no, it does not improve accuracy. It does, however, increase confidence. In a study performed by Tsai, Klayman, and Hastie (2008), they state that as participants receive more information, their confidence increases more than their accuracy (1). This can be viewed more succinctly in this graph (taken from their study).
This overconfidence has real negative impact on your investment success. There is simply no return that can be achieved without risk, and overconfidence is a risk that does not provide a return.
It is, however, a tool used to sell you on the idea of investment success. Unfortunately, complexity as a tactic is employed relentlessly by the financial services industry. All of this data can be tailored to tell a variety of narratives. It is incredible how many different ways you can claim credit for positive performance while deflecting responsibility for negative performance, all the while collecting an advisory fee for their service.
Using this framework can misdirect the client form recognizing the extremely important, yet simple, truth: That this is contributing to material underperformance.
Over a 15-year period, 92.43% of active large-cap managers failed in their attempt to outperform the S&P 500 (SPIVA ii).
Over the past 10 years, the average equity mutual fund investor has earned an average return of 4.9% compared to the S&P 500’s 8.5% average return. The average fixed-income investor has earned an average return of 0.48% while the BloombergBarclays’s Aggregate Bond Index has earned 3.31% (DALBAR iii).
Over a five-year period, only 0.45% of large-cap funds were able maintain position in the top 25% of fund performance consecutively for all five years. Only 11.41% of large-cap funds were able to maintain top-half performance over five consecutive years (SPIVA 2018 Persistence Scorecard iv).
In an effort to predict what will happen next, we ignore the impact of this underperformance. The further we drift from dollar results and what the assets can achieve in terms of goals, the more futile our definition of success becomes.
The Present
Sometimes we all need reminded why we invest. It isn’t just to earn a return, although that is a necessary aspect of it. Your financial life is funded with dollars and your goals are achieved by spending those dollars. The endless data analysis is meant to provide insight on the value of your account, which you already know! Your assets, in dollars, is the only measure that incorporates all relevant data.
This is the starting point of your financial plan. Our process is predicated on understanding what your assets are capable of in the future, not what has led up to this point. You certainly cannot control what has happened, but you can control your financial life moving forward.
Referring back to Ockham’s razor, this is a simple solution. We aren’t ignoring data, we are just choosing to focus on what is important. We must remind ourselves that making decisions utilizing simple data does not equate to a lazy or unsophisticated process. Rather, we are focused and not allowing ourselves to be distracted from managing your financial life.
The Future
Investing as a probabilistic exercise promotes objective decision making. When the measure of success is achieving goals in your financial plan, the process inherently eliminates unnecessary expenses and risk.
Morningstar published a study in 2016 stating that the most effective measurement used to predict future fund success is the fund expense ratio (Morningstar - Fund Fees Predict Future Success or Failure v). In 2017, actively managed funds specializing in US equities had an average fund expense ratio of 0.73%. Compare that with passively managed funds specializing in US equities that had an average fund expense ratio of 0.11% (Morningstar - Fund Fee Study vi). Summarizing these studies: Paying more in fees leaves you with less money to invest and, ultimately, spend. This is the way to use relevant data to improve the success of your financial life.
By relying on a statistical process, such as how we employ Monte Carlo, you can recognize that the order of potential returns can be more important than the return itself. We know it is impossible to influence the order of these returns, or even the returns themselves. We can, however, manage your financial plan to be resilient to these, and many other, potential returns.
Regardless of how the market behaves, we are all left with the same enduring question: What are my assets capable of?
I am not making the case to reduce the usage of data and it’s associated tools. Our Monte Carlo process relies on large amounts of historical data to generate its simulations. I am, however, making a case for limiting the information that gets included in investment decisions. We all have a limited amount of time and skill, and I propose we use those limited resources to improve the process, to improve our analysis, and to focus on what is relevant. We need to manage our financial lives, not measure our financial past.
Sources:
(i) Tsai, C. I., Klayman, J., & Hastie, R. (2008). Effects of amount of information on judgment accuracy and confidence. Organizational Behavior and Human Decision Processes, 107(2), 97-105.
(ii) https://us.spindices.com/documents/spiva/spiva-us-mid-year-2018.pdf
(iii) https://www.dalbar.com/QAIB/Index
(iv) https://us.spindices.com/documents/spiva/persistence-scorecard-march-2018.pdf
(v) https://www.morningstar.com/articles/752485/fund-fees-predict-future-success-or-failure.html
(vi) https://www.morningstar.com/blog/2018/05/11/fund-fee-study.html