When investing, be careful not to confuse complicated with complex.
My inspiration for this post came from reading this essay by Arnold Kling a few years back where he elaborates on a longer essay by Jordan Hall that draws a distinction between complicated and complex. Hall sets the terms:
...[I]n brief the distinction is that a complicated system is defined by a finite and bounded (unchanging) set of possible dynamic states, while a complex system is defined by an infinite and unbounded (growing, evolving) set of possible dynamic states.
Kling's treatment is very helpful as he extends the concept to economics and climate:
When I was a graduate student in economics in the late 1970s, we were trained as if the economy is complicated, but not complex. We were told that if we learned enough mathematics and statistics and applied these tools, then eventually we could predict and control economic outcomes.
In fact, economic behavior is complex. There are too many causal factors, feedback loops, non-linear effects, and unprecedented phenomena involved to enable economists to control the economy precisely and reliably.
....
Climate scientists use computer models, because the problems with which they deal are complicated. But there are multiple models, and they do not agree with one another. That tells me that the climate, like the economy, is complex. There are too many causal factors, feedback loops, non-linear processes, and unprecedented phenomena involved to enable precise and reliable prediction and control.
In contrast, landing a spacecraft on the moon is merely complicated. It is a very difficult problem, but we can arrive at a determinate solution.
I would like to extend this model to the investing world especially from the standpoint of the typical buy-side* investor (AKA, you and me and most all of us).
The money management world loves to overcomplicate things. This is because overcomplication gives a mystique or air of superiority to the wise, benevolent (expensive) investment professional. It also conveniently provides a nice cover for when things don't go so well. As an aside I believe this is a very big part of the investment world's embrace of ESG--perhaps to be expanded upon in a future post.
At the same time that they are embracing overcomplication, they are riding in like valiant knights to save the day. This is not to say that investing is simple. Investing is complicated, but that complication and solutions designed to solve it are not the full story.
If it were just complicated, Wall Street would have solved investing long ago. And it wouldn't have needed a retail investor's money to do so. Investing is complex. This follows naturally from economic behavior including the economic actors and forces within it being complex. Consider a single stock.
We can attempt to value a stock based on a number of different, widely used, credible models (e.g., dividend discounting, free cash flow to equity, multiple of price to book, multiple of price to sales, etc.). These formulations are complicated to a certain degree and can be made more complicated with arguable improvement to the output. What should give us immediate pause is that each of these will almost always yield a meaningfully different answer.
Each model will rely on assumptions, and those assumptions will have their own underlying complications. No matter how hard we try, all the king's computers and all the king's CFAs cannot definitively (precisely and accurately) value a single stock let alone the market as a whole. The best one could hope to do is be right more often than not to a slight but still meaningful degree. Very few highly incentivized, very well funded pros can actually do this. And even they fade with time.
The nature of investing being complex is not simply complication layered upon complication. It is of another dimension entirely. Economic value is ultimately subjective value. It is subject to preferences, tastes that change in unpredictable ways. It is also subject to random events that spawn new, unforeseen paths of development. There are future technologies of which we have not even dreamed and for which all of the physical ingredients are currently before us.
Those in money management on the sell-side* offer the comfortable refuge of 'solving' the complicated. This is dangerous even if unintentionally deceptive. Investing is never solved. It is constantly evolving both from the standpoint of the market external to the investor as well as the investor's own financial goals and risk preferences. Consider the latter an additional layer of complexity with its own complications.
The solution to complex challenges is flexibility. A good financial plan must be adaptive. Elaborate schemes alone will not save it from peril. If anything, they may give a false sense of security along with crippling high costs. Start with straightforward guiding principles, and follow with constant reassessment: What are you trying to achieve? What is at risk? What is the current probability of success/failure? What are the magnitudes of those potential outcomes? How confident should you be in these estimates? What if you're wrong?
Appreciation for the complexity of investing means looking beyond solutions for the merely complicated.
*In traditional industry parlance the buy-side refers to those purchasing investments especially investment products. This could include buying a mutual fund or investing money with a more involved manager. The sell-side is of course those on the other side of the trade selling the investment fund or services. The ultimate buy-side investor is the principal owner of the account--the one who's money is being invested. She may hire a money manager to act as agent for her. It would be his job to take on the role of buy-side investor facing those looking to sell investments to him (ultimately her). So for him it can be confusing since he is selling to his client his services to buy on her behalf. In the industry he is always considered buy-side. The firms he invests his clients' money with are the sell-side. Many a principal-agent problem develops when the buy-side doesn't stay prudently arms length from the sell-side. Think of it as the financial world equivalent of the McD.L.T.
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