The Benefits of Investing Simply
Four Cards
This week, The New York Times cited a puzzle that it claims is a chestnut, although I don’t recall seeing it before. You are presented with four cards, each of which contains a letter on one side and a number on the other. You are told that if a card has the letter “E,” then its reverse will be the number “5.” However, that statement might be false. Your four cards read E, 2, 5, and F. Which cards could help you determine the statement’s accuracy, and which would be unhelpful?
The answer is below. (Pause here if you wish to try the problem on your own.)
- If the card reads E, then if the number is 5 the statement is true. If the number is anything else, the statement is false. Helpful.
- If the card reads 2, then if the letter is E the statement is false. Helpful.
- If the card reads 5, no letter conveys information. Unhelpful.
- If the card reads F, no number conveys information. Unhelpful.
This puzzle was straightforward. Obviously, the first card is relevant, as the number on its reverse directly addresses the thesis. Less obviously, but still manifestly, the second card is useful, because the 2 will disprove the statement if it is paired with an E; and the final two cards are immaterial because their results neither affirm nor disprove the statement. This is, quite literally, elementary-school material. For each card, the logic chain consists of but two links: if and then.
Yet, when psychologist Peter Wason administered this selection test, as it later became called, most university students failed. Those students certainly possessed the ability to connect ifs with thens. However, they did not put those skills to work. The students relied on their intuitions, rather than tackling the task step by step. As a result, they turned what was a simple undertaking—if addressed methodically—into something complicated.
Portfolio Managers
This would seem to be good news for professional investment managers. If stepping to the side, taking a deep breath, and tackling a problem methodically, rather than rushing to a conclusion, immediately puts somebody ahead of 90% of university students, then imagine the managers’ edge when working in their own field—where they spend so much time, have so many research tools, and are paid so handsomely to succeed. They should be able to thrash 99.9% of their amateur competitors, at a bare minimum.
That they probably can. The problem is, outdoing 999 of 1,000 rivals doesn’t get a portfolio manager very far. If there are 10 million involved investors in U.S. stocks (as opposed to those who own equities through mutual funds, or are casual stockholders), then that 1-in-1000 camp possesses 10,000 members. Having the insight to invest simply once sufficed for fund managers. Being a poor man’s Warren Buffett was plenty. Today, there are too many managers who fit that description. The competition among them has become too steep.
Retail Implications
However, if the four-card puzzle currently carries few lessons for portfolio managers, it remains apt for retail buyers. Unlike professional managers, who cannot thrive at their roles unless they frequently and consistently out-think the wisdom of the crowd, everyday investors need not be brilliant. They are not required to beat others. Instead, as with solving the four-card puzzle, their task is keep things simple, so that they don’t beat themselves.
Which means avoiding the avoidable errors that arise from rushed decisions. The whole idea of long-term investing is to align one’s portfolio with the odds. That means: 1) Holding securities that figure to outgain cash more often than not, and 2) Keeping costs very low while doing so. That sounds so obvious as to be useless. Yet many fail to observe those precepts.
Some err by not investing, although they have surplus cash. Others are overly cautious with their retirement assets. (There’s no reason why a 35-year-old’s retirement account—as opposed to other investment buckets—should contain anything but equities.) Others yet overreact to bear markets. Listening to arguments that previous market conditions no longer apply, so that the math that historically has favored equities will not do so in the future, is an emotional decision rather than a logical choice. It is the equivalent of rushing to judgment with the four-card puzzle.
With fund costs, much progress has occurred. Whereas two decades ago I would have written that the most fund investors overlooked the damage caused by high investment expenses (a group that included your columnist, in his early days), those times have changed. Jack Bogle, after all, has become the fund industry’s best-known commentator. Still, many investors overcomplicate their lives—and sometimes their taxes—by churning their portfolios.
To the two above items, I would add a third: chasing nonfinancial assets. Examples including flipping houses, purchasing bitcoin, and trading gold bullion. Many people have made their fortunes in such fashion. However, those are mostly intuitive investments; indeed, I would hesitate to call them “investments.” Such purchases are supported by few (if any) calculations. They replace the transparent math of owning equities or investment-grade bonds with a decision that is largely emotional.
That strategy can work out well. Investing intuitively does not automatically mean failure. Such an approach certainly has a higher success rate than would picking cards at random in Wason’s selection test. However, keeping things simple has historically been the better option—if, paradoxically, not always the easiest to follow.
Friday's Folly
Friday’s column, which praised Morningstar’s new Advanced Portfolio Template (APT), stated that, as of Dec. 31, 2017, AQR Risk Parity Fund(AQRIX) had no U.S. equity exposure. This was not correct; per AQR’s analysis, the fund had a small percentage of effective U.S. equity exposure in U.S. stocks as of that date. Which goes to illustrate another aspect of that column—that Morningstar is in the process of rolling out this enhancement. It is a work in progress.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
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