Keep it simple stupid
Everybody knows the adage Keep it Simple Stupid (KISS). It applies everywhere, even in something complex like investing. Actually, the more complicated the endeavor the more important it is to KISS.
But, like so much ‘good advice’ it’s hard to know how to apply it in practice. After all, isn’t it easy to oversimplify?
What I propose to do in this post is look at thirteen different investing topics and offer my thoughts on how investors can keep it simple.
But, before we get to investing, let’s start with some psychological theory. Human beings have a natural proclivity, woops, excuse me, natural tendency (even to use fancy words) to make things complicated. Scientists have studied this. Researchers at the University of Virginia carried out a series of observational studies to find out how humans go about improving objects, ideas or situations. Their goal was to find out whether we have a natural tendency to make things more complicated or make things simpler when trying to improve them. The result was that across eight different experiments the subjects tended to make things more complicated by adding stuff rather than improving things by taking stuff away. One of the tests involved asking subjects to improve the strength of a lego structure so that it could hold a brick. A minority of the subjects had the bright idea of removing one brick. Most subjects added bricks. Of course now that we know the best way we can be sure we would have been in the smart minority – right?
The researchers made some general observations: Defaulting to searches for additive changes may be one reason that people struggle to mitigate overburdened schedules, institutional red tape and damaging effects on the planet. They might have added that this is why investors struggle to deal with investing complexity. To read the researchers’ article see here.
Let’s looks at a few different topics in investing and see how KISS applies, or at least my take on it.
A simple calculation will tell you whether your annual savings and average return will be approximately right. This can be monitored as you go along. After that it’s simply a matter of generating the highest return you can and living within your means when you retire. A fancy spreadsheet will give precise numbers but can also give you a false sense of accuracy.
How do we know it will work?
The magic of compounding. You don’t need a spreadsheet. A calculator adding a percentage to a fixed sum many times will show this. No need for precision.
What to invest in?
Common stocks offer the highest return over the long haul. The big argument in favor of adding bonds is as a stabilizer, i.e. less volatility. People find volatility disconcerting. But, volatility is no more than a normal bout of stormy weather that comes and goes. Once you learn this it’s less scary. You can actually take advantage of volatility to buy stocks cheap. Ben Graham says: “In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.” (Graham, The Intelligent Investor, 1973) p. 101. Read more about volatility in three posts here.
Choosing common stocks
We only want to invest in superb companies. In a sense, it’s that simple. Choosing them can be relatively simple. There are a few basic requirements: first, they must make lots of cash (rather than reported earnings) without needing a lot of assets to do so. You should learn to understand the company’s cash flow statement. The cash should be more than they need to maintain their existing assets and position in their market; second, they must have opportunities to invest that cash at high rates of return in growth opportunities. To read more see a series of posts on free cash flow here.
Third, they must have minimal debt. If they could pay it all off in a couple or three years from the extra cash the business generates the debt is ok. For more on debt see here.
Fourth, management and the board must have tens of millions or hundreds of millions of dollars personally invested in the common stock of the company. This will make them much more careful with the company’s capital. To read more about management see here.
Lastly, you make sure you understand the business. What is it they do or make? Do you have a good sense as to how they make their money? Try to be a business analyst. Look deeper here.
Bottom line is the company must be a great company. Just because a company is a household name doesn’t make it a great company. In fact, many of those with old boys club management are quite mediocre.
Investing in a world of uncertainty
It is the complexity paradox. Things are so complex and uncertain that we despair of making sense of them. If we try to simplify the world of investing using rules of thumb like price earnings ratios or price to book value ratios, we can easily be led astray. But, because of the complexity and uncertainty we can only make decisions by simplifying things.
The comfort for the individual investor is that professional investors operate under the same debilitating conditions. The playing field is more level than one might expect. Professionals do not have the welters of precise information and high level analysis many individuals think. In fact their fancy models that spit out precise answers are dangerous because they create a false sense of certainty.
Consider the following from Peter Lynch:
“It’s also important to be able to make decisions without complete or perfect information. Things are almost never clear on Wall Street, or when they are, then it’s too late to profit from them. The scientific mind that needs to know all the data will be thwarted here.” (Lynch, One Up on Wall Street, 1989,1990)p.69.
Risk is the chance that things will go wrong. If you invest in a diversified and balanced portfolio of superb companies the chances of things going badly are pretty low. That’s the simple way to manage risk. You must always monitor your companies to make sure they are still superb and are not losing their way. If they do start to lose their way, sell them immediately. Volatility is not a measure of risk. Prices going up and down are perfectly normal. More on risk see here.
Swinging for the fences
That’s what they call it in baseball. In cricket it’s trying to hit a six every swing. Same idea. Don’t do it. Some suggest a bit of mad money for speculations. I wouldn’t waste a penny on speculations. I never take high risk fliers. I don’t like casinos and betting because the odds are against me. Trying to make a quick killing is pure stupidity which should be avoided at all costs. My rule here is quite simple. Don’t do it.
Diversification is essential. It is making sure you don’t have all your eggs in one basket. Much of the diversification I have seen in others portfolios is mindless. I have seen portfolios with a dog from every village, as the German expression goes. Diversification has nothing to do with price correlation, i.e. prices of different holdings going up and down at the same time. Diversification is all about spreading business risks. I find my current twelve stocks based in Canada and the U.S. has plenty enough spreading of risk. They are all great companies. For more on diversification see several posts here.
It’s importance to have some balance in a portfolio. That means some stocks that benefit from higher interest rates and some that do better with low rates. It means some stocks that do well with higher commodity prices and some that prefer low prices. It means some stocks that like a strong economy and others that do well regardless, and so on. There is nothing scientific here. If one of your companies periodically complains in its quarterly report that earnings are hurt by elevated oil derived products you might think about adding a company that is helped by elevated oil product prices. Dig into notion of balance here.
I generally buy at the market price. It’s the simplest way. Some investors get carried away with limit orders. I can buy at the market because stocks I invest in trade with enough volume that my little order has no impact on the market. I don’t use limit orders to try the shave a bit off the price. I’m buying for the long term. I do keep an eye on the spread between the bid and ask and the volume. On occasion I will use limit orders if there is a big spread. More on buying here.
Some investors hang on every word from market prognosticators and pundits about how things look in the market. The truth is nobody can time the market and you shouldn’t try. Nobody knows what the stock market will do in the next six months or year or even several years. As John Templeton says in his Maxim 14: “Too many investors focus on ‘outlook’ and ‘trend’. Therefore, more profit is made by focusing on value.” This is where volatility is your friend. By being volatile, the market periodically serves up stocks at prices below their fair value. Individual stocks can be volatile even when the market is steady. That presents great opportunities. That isn’t market timing. It’s simply a recognition that price and value are not the same thing. The rule is simple. Don’t do it. Read more here.
The ultimate in simplicity is doing nothing. We all know the urge. Don’t just stand there. Do something.
The last time I sold out a position was in May of 2020. The last time I bought a new stock was that same month. That’s a year ago. The real money is made by buying the stock of a great company at a really attractive price and then sitting with it for years. One stock I hold today was bought in 1998. I’ve trimmed it back a bit from time to time as it grew to too large a weighting in the portfolio. Patience is a virtue. Read further here.
If a company starts to lose its way I sell immediately. I don’t wait for a bit of rise in the price. For more on selling, see here. Read more here.
My object with this post was to stimulate some thinking on how the KISS adage can be applied to investing. We have only looked at a few select topics. Everybody approaches investing a bit differently. I am convinced that no matter how you approach it, there is room to ask yourself if you are making things more complicated than they need to be. After all, simple is often better.
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