Tuesday, July 26, 2005

Occam's Razor Applied to Investing

"Pluralitas non est ponenda sine neccesitate" --William of Occam (c. 1285-1349)
(Literal translation: "Plurality should not be posited without necessity.")

As investors, we have a whole smorgasbord of tempting investment entrees. Over the years, based on various motivating factors, I have invested in domestic and foreign stocks, convertible bonds, warrants, commodity-backed securities, government bonds, junk bonds, a spectrum of different mutual funds, CDs, money market instruments, income property real estate and houses. In certain cases, select investments have produced superb returns. However, generally speaking, I believe that we would all be better off keeping our portfolios as simple as possible.

There is a principle called Occam's Razor that is often used in philosophy, theology, science and medicine. It is a principle of parsimony, simplicity and economy that effectively states: "The simplest explanation is the best." (See Wikipedia for a little more background on the topic.) For example, why invoke Martians when more mundane, earthbound explanations will suffice? Or, in medicine, the most common disease that fits all of the patient's symptoms is most likely the correct diagnosis.

The way that I would apply Occam's Razor to investing and personal financial management is as follows:

1. "Perpetual" Portfolio: Strive to achieve a long-term, even perpetual, portfolio that performs well even when left unattended. One of the key reasons I favor equities over bonds is that equities have no maturity date, meaning that no reinvestment of principal is ever necessary--and no need to reinvest means no urgency to buy, too often into the wrong investment, when circumstances are not most favorable.

2. Low Turnover: Don't trade unless you are certain you will be better off after executing the trade. Some investors believe they have an "edge" and can invest profitably in the short run. The obstacles to turning a consistent short-term profit, however, are formidable: bid-offer spreads, transaction fees, taxes, time spent verifying trade details, accounting expenses, and worst of all, painfully seeing the market move against you and reluctantly admitting after the trade that your "hunch" was not correct after all. With all of the uncertainty of outcome of investments in the financial markets, I believe that trading as infrequently as possible is best.

3. No Debt: Don't borrow unnecessarily. Having no debt means never having to repay principal to anyone and never paying any interest. Also, just as with bonds, loans have a maturity date, which means that refinancing is needed, i.e., loan fees, legal expenses and administrative costs have to be paid to lenders. All of these costs can be minimized by simply borrowing only sparingly, when absolutely necessary or otherwise advantageous to do so.

4. Self-Management: Rely on your own wits to manage your own money. When a portfolio is simple, it can be managed by oneself, without the need to hire external advisors, who are more than happy to earn commissions and fees at your expense as an investor. (I spent years professionally structuring fiancial products targeting institutional investors and, not so surprisingly, always in brokering we made more money when the products we sold to "sophisticated" investors had more complex cross-market, multi-currency options embedded. The more bells and whistles, the better--for the broker but not for the investor.) Let's face it--every dollar that a broker or portfolio manager earns is one less dollar in your pocket as an investor.

5. Straightforward Tax Returns: Position your investments so that you can do your own taxes. Fewer transactions during the year and simpler investments mean simpler taxes, so simple in fact that it should be possible to do one's own taxes--without the assistance of an accountant. I find that tax software and online filing help enormously to lessen the burden of figuring out how much to pay Uncle Sam each April.

6. Adequate Income Generation: Make sure you pay yourself first. We all have living expenses. Aside from any income available through employment, investors should arrange for regular investment income through some combination of dividends (on stocks), interest payments (on bonds), and distributions of positive cash flow (on income-generating real estate). Income should be sufficient to cover all living expenses so that one's core portfolio holdings never have to be sold to cover an out-of-pocket expense.

7. No Deadlines: Avoid the stress of deadlines. Having only perpetual instruments in one's portfolio and transacting as infrequently as possible, an investor will rarely have payment deadlines to meet and hoops to to jump through.

8. Quality: Buy quality. Owning high quality assets and companies means that the chance of bankruptcy, events of default, financial distress or other early termination of an investment is minimal.

9. Autopay: Use autopay whenever possible. On the expense side, setting up autopay for credit cards, utilities and all other regular payments greatly reduces the amount of time required in day-to-day financial management. (Note: Credit cards these days offer attractive rebate incentives, which provide a welcome financial kickback for those who pay down their balances monthly and never have to fork over exorbitant interest payments to the credit card companies.)

10. More Time to Enjoy Life: Sit back and enjoy. Having a simple investment portfolio means more time for all of life's activities outside of investing!

That's it. Pretty simple. Taken to the extreme it means having an investment portfolio that can be run effortlessly on remote control. Investments turn a profit and generate income that automatically goes into a bank account, from which ordinary living expenses automatically get paid--no watching the tape, no running around, no checkwriting, no worries.

Now, history tells us that William of Occam got himself into trouble with the Pope in his day by advocating a minimalist existence and idealizing a life of poverty. From his hometown of Surrey, England, he was summoned to Avignon, France, and put under house arrest by Pope John XXII for investigation of heresy for four years, during which time he fled to Munich, Bavaria (now Germany), where he died (most likely quite miserably) in a convent, possibly from the Black Death when it swept through Europe in the late 1340s, some seven centuries ago.

In our modern times, by applying similar principles of simplicity, careful investors ought to be more fortunate than William of Occam. A simpler portfolio ultimately means a richer life, with an abundance of time to enjoy all the little things and pleasures. . . .

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