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 BusinessWeek. Still, 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:

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.