Taking the Razor to Complexity in Investment

How the insights of a Franciscan monk can help us make better decisions about our investments

A colleague did an exercise recently in which he compared the performance of the rand with that of commodities. He found a strong correlation between the two, especially over longer periods of up to 15 years. 

The conclusion is that, despite all the political worries that have beset South Africa over the past few years, including Nene- and Gordhangate and the threat of a downgrade to our sovereign rating, ultimately the performance of commodities has been the most important factor in determining the direction of the rand. (Of course events like Nenegate had a terrible effect on the rand at the time, but it has since then pretty much followed commodities, as it does generally.)

The implication is that a good trader or hedge fund manager taking a position in the currency should not be distracted by the political upheavals or noise that characterises so much of the discourse on the rand’s fortunes, but should stick to what guides the commodity markets.

Cutting away what’s not necessary

I mention the above because it is a good example of the principle of Occam’s Razor, a logical tool that dates back to the Middle Ages. Named after a Franciscan monk and scholar (also spelled Ockham), it is summarised as follows: when faced with two or more competing hypotheses to explain something, the one that requires the fewest assumptions is usually correct.

Also known as the law of parsimony, Occam’s Razor (think of the razor cutting away the more elaborate and fanciful theories) is a useful instrument in our daily lives, whether it’s in business and investment decisions or in dealing with our families and friends. We tend to read into situations things that are just not there, which overcomplicates our decision-making.

A good way to explain Occam’s Razor is through one of its humorous (but equally valid) offshoots, called Hanlon’s Razor: never attribute to malice what can be explained by incompetence or stupidity. I’ve found Hanlon’s exhortation useful when dealing with bureaucracy, for example, or when making sense of referees’ decisions on the sports field.

Occam’s Razor doesn’t rule out complex (or malicious) explanations. It merely reminds us to go through the simpler explanations first before considering the more intricate ones.

That is as true in investing as in any field. Investment analysis often involves complex models that require numerous assumptions. The greater the complexity, however, the larger the dispersion of possible outcomes, which calls into question the reliability of the model.

If, for example, Sasol’s share price correlates strongly with the US dollar oil price, then that is probably the metric of performance on which we should concentrate our research, rather than the intricacies of demand for various downstream products. Those elements should not be discarded completely but simply accorded the attention they deserve and no more.

Diversify, don’t complicate

On a similar note, too much complexity can be the undoing of your portfolio construction. My colleague Patrick Duggan recently wrote of the perils of “diworsification”, when investors undermine their investment goals by overcomplicating the important task of creating a balanced, well-diversified portfolio. The razor is vital when building a portfolio: if you can achieve your asset and sector allocation goals with a handful of stocks, you should not complicate things by owning too many different shares or instruments. For example, if you were to decide you needed gold shares in your portfolio, it would be better to own a handful of good, liquid counters rather than an array of major and minor producers.

This is equally important when it comes to the decision to buy, hold or sell a share. Events may affect its performance in the short term but have little or no impact on its investment case over the long term.

In these cases, one should resist the temptation to sell a share on every bit of bad news that arises and perhaps even use short-term weakness as an opportunity to buy. At the same time, shares that do extremely well in certain circumstances are often best avoided – those circumstances may not arise again for many years, leaving you with a low-quality stock that weighs down performance.

Occam’s Razor can’t guarantee that we make better decisions, but it can certainly make us think of problems in a better way and help us avoid the bigger mistakes. And avoiding the bigger mistakes is often the secret to success.