The Sketchbook of Wisdom: A Hand-Crafted Manual on the Pursuit of Wealth and Good Life
In the endnotes of his brilliant book, Winning the Loser’s Game, Charles Ellis wrote about two of his best friends who, at the peak of their distinguished careers in medicine, agreed that the two most important discoveries in medical history were penicillin and washing hands (which stopped the spreading of infection from one mother to another via the midwives who delivered most babies before 1900).
Ellis’s friends also counseled him there was no better advice on how to live longer than to quit smoking and to buckle up when driving.
The lesson Ellis leaves the reader with is this –
Advice doesn’t have to be complicated to be good.
I have been in the markets for 19 years, which has been a good enough time to make me aware of a profound investor bias toward complexity. Over these years, I have seen too many investors trying to fight complexity by adding even more complexity into their investment process.
The world is complex. Consider the various reasons floating around explaining the market’s fall in the last two months – war, inflation, interest rates, FII selling, China, supply chain disruptions, weak GDP, and over valuations. This is not a complete list, but enough to suggest that the world is complex. And so are financial markets.
How do you deal with such complexity in your wealth creation journey without losing your sanity?
Have an investment process that is elegant in its simplicity.
Of course, this goes against common belief that your investment process must be complex to be profitable. This is because, like the Dutch computing science pioneer Edsger W. Dijkstra said, “Complexity sells better.” Against that, “simplicity requires hard work to achieve it and education to appreciate it.” And not many investors would want to walk on that road less travelled.
Also, a research paper titled The Confounding Bias for Investment Complexity argued that “a preference for complexity is almost hardwired into investors, their agents, and asset managers because the intuition is that a complicated investment landscape requires a complex solution; a complex strategy also supports a higher fee from both agents and managers.”
This is even when “simplicity leads to better investor outcomes not because simplicity in and of itself produces better investment returns, but because a simple strategy encourages investors to own their decisions and to less frequently overreact to short-term noise.”
So, what’s a simple investment strategy that also works?
Let me keep it simple and share with you the ten-parts strategy outlined by John Bogle in his book The Clash of the Cultures.
It’s simple and it works. I can vouch from my 19 years’ experience in practicing, and profitably, most of what Bogle advised –
- Remember reversion to the mean: Selecting your investments looking just that the past is dangerous. Markets are like a pendulum. And like Ben Graham quoted Horace said at the start of his book Security Analysis, “Many shall be restored that are now fallen and many shall fall that are now in honor.” People forget that markets are mean reverting when returns get way ahead of the fundamentals, and everyone’s getting rich. But, like with Cinderella at the ball, the clock does strike 12, and everything turns into pumpkins and mice.
- Time is your friend, impulse is your enemy: Time is your greatest ally in the compounding journey. Take advantage of it. Against this, impulsive actions like timing the market, buying what’s hot, selling what’s plunging, etc. are your enemies. Avoid such impulsiveness.
- Buy right and hold tight: ‘Buy and hold’ does not mean ‘buy and forget.’ If you have done your work well, and the business continues to do well, hold on to it tight Thinking (actually) like an owner should help here.
- Have realistic expectations: There are two sources of stock market return – one, investment return and two, speculative return. The former depends on the underlying business you own – its growth, profitability, return on capital, balance sheet strength. The latter depends on the speculative tendencies of the market participants. We get into trouble when we base our expectations on speculative return, for that is largely based on the opinion of others. Focusing on what the business is doing and basing our return expectations on that is the way to go.
- Forget the needle, buy the haystack: This is where I have changed my mind in the last few years. The haystack Bogle refers to here is the “market” and he’s advising to buy index funds that track the broader market instead of trying to find individual stocks (needles). If you are a “know-nothing” investor, or someone looking to diversify outside general equity funds, a broad-based, low-cost index fund or ETF is a good idea.
- Minimize the croupier’s take: Bogle write in his book, “After the heavy costs of financial intermediation (commissions, spreads, management fees, taxes, etc.) are deducted, beating the stock market is inevitably a loser’s game for investors as a group…[like] after the croupiers’ wide rakes descend, beating the casino is inevitably a loser’s game for gamblers as a group.” When you focus on the potential returns on an investment, also consider the cost you would incur over its lifetime. Reduce the costs from the potential returns, for that is the rate at which your money would compound. High cost is the reason I don’t advice PMS services. Keep it simple. Find a good, well-diversified equity fund with much lower costs, and invest there.
- There’s no escaping risk: However smart and experienced an investor you are, there is no escaping risk while investing in the stock market. Bogle writes, “When you decide to put your money to work to build long-term wealth, you are not deciding whether or not to take risk, for risk is everywhere. What you must decide is what kind of risk you wish to take.”
- Beware of fighting the last war: We suffer from recency bias, and often decide to invest looking at how things have been in the recent past (like looking at recent stock price movements). Past is a great teacher and an indicator of what may come, but you should not expect the recent past to continue into the future. That happens only in excel sheets, not in real life.
- The hedgehog bests the fox: Bogle writes, “The Greek poet Archilochus tells us that the fox knows many things, but the hedgehog knows one great thing. The fox – artful, sly, and astute – represents the financial institution with investment professionals who know many things (or at least sincerely believe that they do) about complex markets and sophisticated strategies. The hedgehog – whose sharp spines give it almost impregnable armor when it curls into a ball – is the financial institution that knows only one great thing: Long-term investment success is based on simplicity.” Be the hedgehog.
- Stay the course: Most people who start into investing with a sound process fall prey to the emotions of envy, greed, fear, and abandon their process. The ones who do well in the long run are those who stay the course, come what may. Of course, a process must evolve with time, but sticking to what you think is best for you and what works in the long run is what matters.
Oliver Wendell Holmes, the American physician, poet, and humorist, said –
I wouldn’t give a fig for the simplicity on this side of complexity, but would give my life for the simplicity on the other side of complexity.
Simple can be harder than complex. You have to work hard to get your thinking clean to make it simple. But then, as Steve Jobs said in an interview in 1988, “…it’s worth it in the end because once you get there, you can move mountains.”
That’s also true for investing for wealth creation. In practicing simplicity, and staying the course, over time you can also move mountains.
Thank you for reading.
- Winning the Loser’s Game by Charles Ellis
- The Clash of the Cultures: Investment vs Speculation by John Bogle
- A Wealth of Common Sense by Ben Carlson
- The Confounding Bias for Investment Complexity