Overengineering

I’m bound to repeat myself here, at least in part. This maybe a function of my incompetence in clarifying some concepts or perhaps of the (limited) number of readers of this blog.

John Kenneth Galbraith once said “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.” Brilliant words, but why exactly do they sound so true? Why does it need to be this way? I think it all springs from a mental picture which works in the physical world but not in investing.

Schematically it goes like this. Comparing two cars, the more powerful the engine the more speed you gain by increasing RPMs:

Figure 1

Those lines are not really straight (torque is not constant throughout) but there is never a time when you increase RPMs and speed goes down (unless you blow your engine).

Now think of investment returns; the instinct of most is to relate time and returns in a similar fashion:

Figure 2

But in reality the relationship between low and high risk assets looks more like this:

Figure 3

Figure 4

Now for many years we have known that playing with those green arrows in a real portfolio is pretty much futile, especially after you take out the costs involved. “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in the corrections themselves.” said Peter Lynch, a legendary investor. Your net result is hence likely to be as below:

Figure 5

But dreams or wishful thinking are hard to die and so the investment management industry has come up – and continues to come up – with creative ideas and powerful marketing stuff: to achieve superior results read our research, trust our brand, we know how to pick stocks, our models make you win, we’ve got smart beta, and so on.

I’m not saying that some professionals are not good investors or that exceptional talent is nonexistent. What I am saying is that they are generally not available on shelves of massive money management institutions or financial supermarkets. Most of these don’t have a better crystal ball than any of us (hard to believe) but they do have the stamina and power to make sure you listen to their message.
You would be surprised how far you can go if you paid attention to a very few things: time horizon and purpose of your investments, diversification and valuation.