Investing can quickly become a very complicated topic. A wide range of complex terms, formulas and strategies can end up confusing investors. This may lead to an inefficient allocation of capital in the long run.
For example, investors may buy shares in a company that operates in an industry outside of their sphere of knowledge. As a result, they may be unable to ascertain the size of its competitive advantage versus peers. Similarly, investors may use complex formulas to value companies or short-term trading strategies to reduce risk. However, they may end up failing in this aim, while reducing their return prospects.
Of course, complicating the process of investing is not a new phenomenon. It has suffered from overcomplication for many years, with investment professionals often being the worst offenders in this regard. Indeed, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) chairman Warren Buffett (Trades, Portfolio) discussed the possible reasons for investment professionalsâ desire to complicate the task of allocating capital in the 1987 annual letter to shareholders:
âMost professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising âTake two aspirinsâ?â
A simple strategy
Instead of following his peers in using complex strategies when investing, Buffett prefers to maintain a simple strategy. In the same 1987 letter to shareholders, he stated:
âWhenever Charlie (Munger) and I buy common stocks⌠we approach the transaction as if we were buying into a private business. We look at the economic prospects of the business, the people in charge of running it, and the price we must pay.â
In my view, Buffettâs strategy could be a useful method for any investor to use when managing their portfolio. At its very core, buying stocks is almost identical to purchasing a private business. The only real difference is the small size of shareholding, and limited control, that an investor in listed companies may have versus shareholders in smaller private businesses. Therefore, approaching them in the same manner could be a sound means of assessing their risk/reward opportunities.
Indeed, investors in private businesses are unlikely to worry about factors such as short-term volatility, as measured by beta, or in dynamically hedging their positions by shorting other stocks. They are even less likely to try to value a private company using complicated methods that they do not fully understand. Therefore, the added value that complex strategies bring to managing investments could prove to be far more limited than it first appears.
A three-step approach
Buffettâs views from the 1987 shareholder letter also highlight his use of a very structured investment strategy. He has a three-step process that assesses the quality of a business, the competence of its management team and its valuation.
In my opinion, this rigid approach can help investors to avoid using unnecessary ideas and strategies that add little value. A structured approach may also lead to greater discipline and a more direct comparison between companies operating in the same sector. This could make it easier to identify those companies that have the greatest competitive advantage versus their peers.
In addition, there is no evidence that greater complication leads to higher returns. Buffettâs 20% annualized return, versus a 10% compounded return for the S&P 500, since 1965 shows that simplicity can lead to great success. Therefore, a similar approach could be the most logical investment strategy in the long run.
