Keep Investing as Simple as Possible

Predicting the quality of a fine wine has long relied on the sniff-swish-and-spit taste method. Critics use palettes and noses honed over years to assess a wine's future value. Results, unsurprisingly, can be mixed. Two vintages once deemed equal quality can end up varying in price by tenfold or more.

Princeton economist Orley Ashenfelter looked at this and shook his head. "I had never known if [fine wine] was all a bunch of B.S., [so my wife and I] tried some older Bordeaux wines, and they were fantastic," he once told BusinessWeekStill, the price differences were astounding. "I would say: Now wait a minute, 1961 Chateau Lafite costs, say, $5,000 a case, and '62 costs $2,000 a case, and '63 costs $500. So what's the difference? What's going on here?"

"It was mainly the weather," he said.

We've always known that weather affects the quality of a vintage, but Ashenfelter doubled-down and showed that just four variables -- the age of the vintage, the average temperature during growing season, the amount of rain at harvest, and the amount of rain in the months before harvest -- accurately explains 80% of the variation of a wine's future price. No swishing or spitting required.

In his paper, "Predicting the Quality and Prices of Bordeaux Wines," Ashenfelter notes that renowned wine taster Robert Parker ranked the 2000 vintage Bordeaux as one of the greatest ever produced. "And yet we learned this without tasting a single drop of wine."

Ashenfelter's system isn't perfect. But just as Michael Lewis's book Moneyball showed how baseball manager Billy Beane replaced the traditional, subjective system of valuing a player with an unemotional numbers-based approached, Ashenfelter outsmarted wine snobs with a simple formula that stripped the problem down to the few variables that mattered most. No emotion, no opinion. Just the facts, thank you very much.

Investors may be wise to do the same.

There are no points awarded for difficulty in investing. The investor with the most complicated model or the most elaborate theory doesn't always win. Indeed, elaborate theories can often be the fastest route to self-delusion. The Motley Fool's Seth Jayson put it nicely: "It begins to sound fatalistic, but I have come full circle on this to the idea that simple rules work far better than deeper thinking, because most of that deeper thinking is just an exercise in bias confirmation."

In 1981, Pensions & Investment Age magazine published a list of money managers with the best track records over the previous decade. One year, a fellow named Edgerton Welch of Citizens Bank and Trust Company topped the list. Few had ever heard of Welch. So Forbes paid him a visit and asked him his secret. Welch pulled out a copy of a Value Line newsletter and told the reporter he bought all the stocks ranked "1" (the cheapest) that Merrill Lynch or E.F. Hutton also recommended.

Welch explained: "It's like owning a computer. When you get the printout, use the figures to make a decision -- not your own impulse."

I'm not suggesting a similar approach. I couldn't find what ever happened to Welch's track record. But as Forbes summed it up, "[Welch's] secret isn't the system but his own consistency."

Simplicity and consistency. That's the key. It's taking emotion out of the equation and focusing on the few variables that count. Ashenfelter, Beane, and Welch all believed in this idea. Study enough successful investors, and I think you'll find it as a common denominator.

In an interview just before his death in 1976, Benjamin Graham, Warren Buffett's early mentor, was asked about investing philosophies:

Q: In selecting the common stock portfolio, do you advise careful study of and selectivity among different issues?

A: In general, no. I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost. To that very limited extent I'm on the side of the "efficient market" school of thought now generally accepted by the professors.

Q: What general approach to portfolio formation do you advocate?

A: Essentially, a highly simplified one that applies a single criteria or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole -- i.e., on the group results -- rather than on the expectations for individual issues.

Again, simplicity and consistency.

Some have proposed simple investing rules that have a good record of success. In his book The Little Book That Beats the Market, hedge fund manager Joel Greenblatt proposes ranking a broad group of stocks by two variables: earnings yield (cheap companies) and return on capital (good companies). Buy a basket -- say, 30 -- of the highest-ranked stocks. Rinse, repeat. Greenblatt shows this simple formulaic approach has easily beaten the market over a multi-decade period.

Wharton professor Jeremy Siegel ranked S&P 500 companies by dividend yield and showed something similar:

Dividend Yield

Average Annual Return, 1957-2006

Highest

14.22%

High

13.11%

Middle

10.55%

Low

9.79%

Lowest

9.69%

S&P 500 average

11.13%

Source: Siegel, Stocks for the Long Run.

Other studies show a basic rebalancing of assets -- buy stocks when they're down, sell bonds when they're up, and vice versa -- every year can lead to superior returns if done consistently over time.

Past performance is no guarantee of future return. These strategies may be entirely spurious. The more data you search through, the higher the odds you'll find what you're looking for, whether it's real or cherry-picked. And as Einstein put it, "Not everything that can be counted counts, and not everything that counts can be counted." Brand loyalty, corporate culture, and trustworthy management are all things that can't be captured in a formula, but that we know are characteristics of great investments.

But many of us are emotional investors. We often make completely different decisions based on tiny changes in mood or circumstance. Simple, consistent, and formulaic investment approaches don't suffer from that bias. Any chance to substitute emotion with unbiased facts is likely a step in the right direction.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

If you're interested in more big-picture stuff, check out my report, "Everything You Need to Know About the National Debt." It walks you through step-by-step explanations about how the government spends your money, where it gets tax revenue from, the future of spending, and what a $16 trillion debt means for our future. Click here to read it. 


Read/Post Comments (21) | Recommend This Article (85)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 22, 2013, at 7:14 PM, tdotsports1 wrote:

    Great read.

  • Report this Comment On July 22, 2013, at 7:24 PM, neamakri wrote:

    I own nine dividend-paying stocks. Each was selected by comparing their dividend with their history of reliable payments (simple!).

    After that I checked the payout ratio, the Graham Safety, and what the analysts expected for the future (three simple checks).

    This dividend system is so simple. I just check the market 2-3 times a week as a hobby. In reality I could just look once a month to verify everything is okay, and reinvest my accrued dividend money back into more stock.

    There are two beautiful advantages to dividends. (1) you reap the dividend AND keep the stock! ..no need to sell to make a profit (2) as the stock price fluctuates, you don't care!

  • Report this Comment On July 22, 2013, at 7:29 PM, TMFBoomer wrote:

    Awesome article, Morgan. I'm definitely on board with simplicity. When Ben Graham started investing there was probably a dearth of information. Now we have so much we have trouble deciphering it. Good to stay focused on what matters and filter out all the noise!

    Isaac

    TMFBoomer

  • Report this Comment On July 22, 2013, at 7:52 PM, SkepikI wrote:

    To Butcher a quote from Forrest Gump: Simple is as Simple does. The more complex I make my life, the more angst I acquire. Two simple tests eliminate most of the stress from my investing life for single stocks: Dividend Yield and P/E less than 3% and over 12, I resist and think twice. Occasionally I break my rules nearly always to my regret.

    Think about it: If I proposed to you a deal or job where you would have to worry all the time, do complicated analysis and LOSE most of the time, would you say, "yah, sign me up"? If you leave simple, that's the decision you make.

    Long F, bot under 12

  • Report this Comment On July 23, 2013, at 3:09 AM, GregTrocchia wrote:

    A subtle point on the topic of cherry picking: The more complex the model, the greater the likelihood that the results are over-fitted, which makes past performance seem better at the price of future predictive power. Here is quote which sums it up nicely:

    "With four parameters I can fit an elephant and with five I can make him wiggle his trunk." — John von Neumann

    If, when you try to use that model (either on paper or for real), it no longer seems to perform anywhere near as well as you expected, that is a warning sign that the outperformance was really just over-fitting (there could be other reasons for this, but most of those other reasons are not any more flattering for your model). In any event, the potential for over-fitting is yet another reason to prefer simpler models to ones with more "moving parts".

  • Report this Comment On July 23, 2013, at 5:16 PM, timc1981 wrote:

    A person can be overly simplistic which isn't good either. I really do agree that there is a very simple model. Start with good companies, target a few metrics, such as current ratio, PE, PEG, Price To Book, Debt Levels, Profit Margins, overall consistency. Buy low, and wait to sell high.

    It gets more difficult when facing decisions like what to do when one didn't read a piece of news about the company that would have made them decide against purchasing this stock...and now the price went way down, and won't be recovering any time soon.

    So, the motivation for the average investor whose experienced these things is to try to gobble up all kinds of information, which is diametrically opposed to the premise of this article. It really can be a guessing game, which I suppose is the argument for diversity.

  • Report this Comment On July 23, 2013, at 5:18 PM, TMFHousel wrote:

    <<which I suppose is the argument for diversity.>>

    Exactly.

  • Report this Comment On July 23, 2013, at 5:49 PM, jordanwi wrote:

    Do you buy bonds Morgan? If so, through a Vanguard product?

  • Report this Comment On July 23, 2013, at 5:55 PM, TMFHousel wrote:

    I don't own any bonds right now, no. My non-stock assets are mostly in a high-yield FDIC-insured savings account that yields 0.85% (Capital One).

  • Report this Comment On July 23, 2013, at 6:43 PM, Mega wrote:

    Graham was wrong about security analysis not working any more. At that same time, Buffett's very similar investment process was shooting the lights out.

    Graham stopped aiming for the highest returns, and stopped achieving them.

  • Report this Comment On July 24, 2013, at 10:50 AM, redlight63 wrote:

    Being from a manufacturing process improvement background I like the Deming quote, "All models are wrong. Some are useful." Suffice it to say I am an advocate for keeping it simple.

    Redlight63

  • Report this Comment On July 24, 2013, at 3:01 PM, mikecart1 wrote:

    I believe in dividends and my biggest holding by far has a 5%+ dividend right now. Higher in the past. The stock has gone up over 150% since I originally bought it and with reinvested dividends I continue to build shares at a fast rate (since it is my biggest holding).

    It makes keeping your money in the bank seem a waste. The best part is seeing that quarterly dividend hit my account and my all my wildest dreams come true.

  • Report this Comment On July 24, 2013, at 7:52 PM, MartyTheCanuck wrote:

    I do well with a few metrics only.

    Growth - I want to see growth of sales and profits over 10 years. What was the impact of the 08-09 recession on sales-profits ?

    ROE - above 15%, or better 20%

    Debt or Cash position - how solid is the balance sheet ?

    #shares outstanding - are they issuing shares ie diluting to grow, or using free cash flow ?

    Is the PE or P/FCF reasonable, or is it a true deal ?

    If it meets all these 5 criterias, it stands a chance of ending in my portfolio. I could write an article on each of these 5, from the reasoning to the subtleties of each of them, but I can decide in 5 minutes if a stock is worth a bit more research.

  • Report this Comment On July 25, 2013, at 8:24 AM, daveandrae wrote:

    When it comes to keeping it "simple", I like Charlie Munger's interpretation the best. ......

    "Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns six percent on capital over forty years and you hold it for that forty years, you're not going to make much different than a six percent return - even if you originally buy it at a huge discount. Conversely, if a business earns eighteen percent on capital over twenty or thirty years, even if you pay an expensive looking price, you'll end up with one hell of a result."

    Amen.

  • Report this Comment On July 25, 2013, at 5:02 PM, MoonMullins wrote:

    Great article. Very sound advice.

    I'd say it's 98% accurate - the only correction being Forbes' assertion that it's consistency that counts, not the system.

    In fact it's both.

    Buy enough high P/E stocks consistently and, well, things won't turn out too well for you. Ditto for many other flawed systems. As Ben Graham might have said, your results would be "most unsatisfactory."

  • Report this Comment On July 25, 2013, at 11:23 PM, Polecat423 wrote:

    When I joined the military I was taught the KISS method: Keep it Simple Stupid

  • Report this Comment On July 26, 2013, at 10:52 AM, AnsgarJohn wrote:

    There are lots of systems that work (see the Guru Investor) the key is choosing one that makes sense to you, that you can stomach, so you don't panic when in the short-term when it doesn't seem to be working. That's Aswath Damoradon?s advice if I remember correctly.

  • Report this Comment On July 26, 2013, at 2:59 PM, GVK2902 wrote:

    Peter Lynch once said that "If you can't explain to an 11 year-old in 3 minutes, why you're buying a stock, you shouldn't buy it."

  • Report this Comment On July 26, 2013, at 4:03 PM, DavidBressler wrote:

    Another "simple" thing to look at when thinking about dividend stocks is the dividend increase rate over time. If you pick a company that consistently increases its dividend, you have a growing income stream that often will keep pace (or beat) inflation.

    Have a look at more simple tips for people who are new to dividend investing: http://ElephantsPaycheck.com

    db

  • Report this Comment On July 26, 2013, at 5:10 PM, ParaBellum16 wrote:

    AMEN to those comments re simplicity in investing. I was a F/C with three of the largest Wall Street retail firms from 1984 to 2002. I can tell you clearly - from experience - that all those wildly complicated formulas that are supposed to unralvel and reveal the "Secrets" to investment success are, by and large, just elaborate exercises in economic academia. In 1990 I designed a quasi-managed investment program modeled around what I strongly believe to be the most productive, calm, and understandable investment approach, the "Dogs of the Dow" process. I was far ahead of the times - Wall Street hadn't discovered this and wouldn't come up with any platforms that used it until about 1995 Same with insurance companies in variable annuities. And these were sorry substitutes for the real deal since the package of 10 stocks was inflexible, i.e. a person could not weed ot a real loser in the mddle of the year if warranted (think o Woolworth in 1991 when dividends were first cut 50% then dropped entirely the next quarter. That was a real LOSER that needed to be taken out before time). I had to write my own marketing brochures for the program which the compliance departments at the time allowed (not today, though). It became the cornerstone of my advisory business and returned to my clients the most profitable and consistent rewards both short and long term of ANYTHING I ever did for them. Of course, it will never be a .com stock-like performer, but you sleep well at night, are forced by the discipline to exercise the "Buy Low, Sell High" mantra, and have a focused rationale for what to buy and when, and what to sell and when (the sell side is the most important part - think of how many things your advisor has asked you to buy vs. how many he he/she has asked you to sell and for what good reason. Think on that - few have sell side philosophies, just BUY!BUY!BUY!) I use the Dof theory for my own account now that I am retired, Beats the Dow generally. Provides me a growing dividend income stream. Requires almost no activity or frenzied trading. Is relatively tax efficient and keeps trading costs at a minimum. I don't really need to spend money on all the super-hyped newsletters that promise fantastic gains but usually deliver only fantastic claims. Gains vs. claims ... hummm. I get gains my way. What does your approach require of you, cost you, and deliver to you in a year after year after year manner? Dogs of the Dow. I was one of the first using it and now with a 25 year track record I can tell you I believe in it wholeheartedly. If you will stop looking for glamour in your investment approach and insted focus on gains without needless hassle, consider the Dog approach. The Fool can help you with that if you are unfamiliar - they (us) picked up on it pretty early, too. About 1994 - 1995 as I recall. You hear those Dogs barking? They are calling to you ...

  • Report this Comment On March 02, 2014, at 5:33 PM, ElliotJStamler wrote:

    Once again Morgan Housel has written a column of pure wisdom and canny insight. It has always amazed me how some very, very rich people hire financial advisors to get them into all kinds of esoteric investments which don't pan out. Successful investing does require brains and care and effort but it does not require an investor to become a financial expert. In the pastor 4 1/2 years my portfolio has increased cumulatively 430%...and while I certainly have my own investment rules they and my investments are pretty basic and simple. And I am NOT diversified and I am no financial whiz. Morgan writes beautifully and the only other financial writer I ever read in his class was the late Louis Rukeyser.

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