Why we're bad at investing part 1: We prefer complexity

Warren Buffett once said, “There seems to be some perverse human characteristic that likes to make easy things difficult.”

In his book What Works on Wall Street, James O’Shaughnessy writes about an experiment conducted by psychosociologist Alex Bavelas which demonstrates this fact in action.

I’ll summarize the experiment as briefly as I can and explain how it applies to our perception of finance and markets.

Two subjects, O’Shaughnessy calls them Smith and Jones, are given a task that neither of them has any expertise in. They are asked to distinguish between pictures of healthy and sick cells, using trial and error.

They can’t see each other while the experiment takes place. In front of each of them are two buttons—one marked “healthy,” and one marked “sick”—which they are to press after they see each picture. After each guess, they are immediately informed via a signal light whether they guessed right or wrong.

Of the two participants, only Smith is getting true feedback. Jones is not getting feedback on his actual performance; rather, he is seeing the same feedback as Smith, which has nothing to do with his own answers.

After the first round of slides, a moderator asks both Smith and Jones to explain what they learned from the process—that is, what rules they have created in their minds to help them judge whether a cell is healthy or sick.

Smith’s feedback is clear, direct, and simple. Almost too simple. Jones, on the other hand, has constructed an elaborate patchwork of concepts to explain the randomness he saw in his results.

Before the next round begins, both Smith and Jones are asked to predict who will score better in the next round. Both of them decide that Jones has a better grasp of choosing between sick and healthy cells. They have been fooled by the complex and elaborate explanations cooked up by Jones as a way to make sense of the random results. This was consistently observed with most of the Smiths and all the Joneses.

Similarly, a recent study by Adams et al. published in Nature, involving problem-solving experiments, found that “people consistently consider changes that add components over those that subtract them.” In our weakness, we are instinctively attracted to solutions that are more complex. Elegance and simplicity do not come naturally to us at all.

When you think about how this applies to the financial markets, it makes perfect sense. The complex answer always seems more intelligent. We watch the financial news networks to hear experts explain the market’s movements to us, and expect those same experts to predict which stocks will outperform going forward.

We look for patterns because we want to explain what happened and predict what we think will happen. And just like Jones, if you look hard enough for a pattern, you’re sure to find it!

The reality of most financial commentary is that we try to assign an explanation to market occurrences after the fact. We’re Jones, getting random feedback on sick and healthy cells, and trying hard to identify patterns. Or we’re Smith, listening in awe to Jones’s intelligent, thoughtful process, which we feel is superior to our own simple methods.

In any event, we need to be aware that we all have a bias to preferring complexity over simplicity, and this makes us vulnerable to mistakes: not just incorrect decisions, but a preference for complex, illiquid, and costly investment products that don’t actually provide any benefit to us.

Understanding that our goal should be to pursue simplicity, not complexity, is an important step in designing a thoughtful investment strategy.

The portfolio manager’s perspective

I was reminded of this topic this past week when reading this writeup of NVR by

Michael Kandolin

. He linked to the now-legendary Norbert Lou writeup on Value Investors’ Club. Reading it, I was struck by its simplicity and clarity of thought. It’s around two printed pages. No appendices. No charts and tables. No 10-year projections (in the non-finance world these go by the name “wild guesses.) Just a clear, concise, and logical description of why this is a great company trading at a great price.

And to wrap it all up in a bow, this was a grand slam investment for Lou - the stock is up around 420x since he published this piece.

Simplicity works. And yet we are drawn to complexity. That’s one reason we are bad at investing.