Why are simple things so appealing?
When we see the Washington, DC skyline in the evening, there’s no question about what draws our eyes: the clear, clean lines of the Washington Monument. Nearby sits the Smithsonian Castle—a Gothic Revival structure built about the same time. Its design was intended to evoke the medieval universities of Europe and England. But the Monument dominates, and not just because of its size. There’s something about simplicity that is appealing—in architecture, in knowledge, and in investments.
Philosophers call this Ockham’s Razor, the principle that the simpler explanation should be preferred, so long as it’s compatible with what we observe. It’s incredibly powerful in fields as diverse as particle physics and textual criticism—explaining why the light from the sun is fundamentally the same as the light of a campfire, although one is 93 million miles away. But it’s not clear why it works—why solar electromagnetic radiation might not be fundamentally different than coming from a candle.
Practically, it has to do with probability. If you have a common reason or an exotic explanation why someone has a sore throat, runny nose, and mild fever, it makes sense to go with the more likely explanation. Chances are, they have a cold. In addition, simple rules tend to make better predictions than more nuanced models. When deciding whether to wear a raincoat, looking out the window is usually more accurate than consulting your weather app, even though the weather app is tied to the National Weather Service. More to the point, I used to work with econometric models for the United States Government. Those models were filled with dozens of variables that helped them fit their output to the historical data. But having more equations made them worse at predicting the future, because many of those factors were one-shot items.
When it comes to business and investing, it’s not surprising why simple rules rule: the more issues a business has to manage, the more things there are to go wrong. Recently, SunEdison filed for bankruptcy—a company with over $10 billion in debt. Their business had grown dependent on acquisitions, federal tax credits and YieldCo spin-offs. When their financing started to dry up in the middle of last year, this 20-year old company collapsed amazingly quickly.
Log chart, SunEdison. Source: Bloomberg
That’s why simple approaches often beat complex models. Warren Buffett once explained why he liked the cigarette business: “Make it for a few pennies. Sell it for a dollar. It’s addictive. And there’s great brand loyalty.” Sophisticated, nuanced business plans may appeal to our inner nerd, but basic building blocks get the job done, while more layered strategies blow up.
In art and architecture, there’s no accounting for taste. Some folks like ornate, rococo designs. But if you’re thinking an investment, ask yourself: could I explain this concept on a napkin, in crayon? If you can’t, it’s probably too complex.
Douglas R. Tengdin, CFA
Chief Investment Officer