“Simplicity has a way of improving performance through enabling us to better understand what we are doing.” – Charlie Munger
Tren Griffin tells a great joke in his new Charlie Munger book that describes the needless complexity many intelligent people try to inject into the decision-making process:
Too many people take a situation and create complexity where none is needed. Take, for example, the old joke about unnecessary complexity at the National Aeronautics and Space Administration (NASA). The storyteller starts by saying that early in the space program NASA discovered that ballpoint pens would not work in zero gravity. NASA scientists spent a decade and huge amounts of money developing a pen that wrote not only in zero gravity but on almost any surface, at extremely low temperatures, and in any position of the astronaut. The punch line is: the Russians instead used a pencil.
The first thing that popped into my mind when reading this was that the majority of institutional investors act like NASA in this situation. They take the complicated route to try to solve a problem without even considering the simple one that’s staring them right in the face.
I was at an industry conference in 2010 with a large number of foundations and endowments in attendance. The chief investment officer for a well-known university with a very large endowment fund was giving a presentation on how they had changed things up following the 2007-09 crisis. Many of these multi-billion dollar funds were stuck in illiquid investments and had to scramble to find sources of liquidity to pay for their share of the operating expenses during the crash.
This CIO described a fairly complex tail-hedging strategy that their team had come up with so they wouldn’t run into the same problems during future meltdowns. The university’s spending policy required a minimum of 3-4% of the endowment’s market value for annual spending needs. So let’s say this was a $10 billion fund. Their annual spending amounted to $300-$400 million and they wanted that amount to be available in the event of a market collapse.
We were told the the annual cost of implementing this tail risk program was in the range of 70 to 100 basis points. So it wasn’t exactly cheap, but they were willing to accept that cost for the comfort of knowing they were hedged. He didn’t go into the exact details, but from the sounds of his description it was something of a Nassim Taleb black swan fund. They had things all calculated out so if another 2008-type event occurred in the future, this hedge would provide the $300-$400 million they needed.
You have to remember, at that time, many people were sure that the markets were going crash again very soon. Everyone was still operating under a bunker mentality. Tail risk funds became one of the hottest selling strategies as the generals of these funds were all busy fighting the last war. So all of my peers in the institutional community in the audience were furiously scribbling in their notepads with questions and ideas about how to implement this type of thing themselves or through an outsourced manager.
At the same time I was doing some back of the envelope calculations. The fund was willing to pay close to 1% per year, or around $100 million, to hedge their annual spending needs. Since they only needed 3-4% of the portfolio to accomplish their goal, that means if the 2008 scenario didn’t come into play once every 3-4 years or so, this would be a a money losing hedge.
Costs aside, my next thought was this — if this fund knew their exact pain threshold — again $300-$400 million — why not just keep that amount of money in ultra safe securities? They could put it in intermediate or even short-term treasuries, some of the safest, most liquid securities in the world. Treasuries have also historically provided a flight to safety premium when the equity markets crash. They would be giving up on other potential investment opportunities, but they would have given themselves peace of mind by knowing that their disaster scenario would be covered.
Also, they were paying almost as much for the hedge as they required for spending needs.
One of the things that has always amazed me about professional investors is that complexity tends to be their default choice. Many assume that a complicated approach must be the right one because it sounds more intelligent. When I started my career I was the same way. The intelligent-sounding solutions and investors impressed me the most because I didn’t understand how things really worked.
When I was finishing up my book, the editors at Wiley gave me three different cover options to choose from. The only one with a graphic included this picture on the front (which is the one we ended up using):
So many investors choose to subject themselves to the maze of complexity and impossible decisions. They never stop to consider that there could be an easier route. Maybe the hedging program instituted by that endowment fund will do the trick. You never know. But the point is that they likely never even considered that there was a much simpler way of protecting their spending needs, literally the reason their fund exists in the first place.
Every single great investor or business person I’ve read about over the years discusses the importance of simplifying in order to succeed. Yet the majority of investors are constantly looking for ways to make things more complex and complicated.
Your Very Own Black Swan Strategy
Advice Doesn’t Have to be Complicated to be Good
And here’s the stuff I’ve been reading this week:
- Seth Godin on the fundamental building blocks of growth for a firm (Seth’s Blog)
- What a bear market might teach us (Jason Zweig)
- Keeping things simple and tuning out the folly (Farnam Street)
- Investing from a simple premise (Abnormal Returns)
- Simple forecasts beat complex ones (Alpha Architect)
- Investment clocks and asset allocation (Monevator)
- Getting my ass handed to me by the world’s largest hedge fund (Medium)
- The Big Short looks like it’s going to be great (The Big Short)
- Fundamentals are only half the story (Reformed Broker)
- Life’s Work: An interview with Andre Agassi (HBR)
And in case you missed it, here are some of the posts and articles about my big career move this week:
- My Next Step (AWOCS)
- Ben Carlson Joins Ritholtz Wealth Management (Reformed Broker)
- Ritholtz Announces Institutional Asset Management (Big Picture)
- Ben Carlson Joins Ritholtz Wealth Management (Irrelevant Investor)
- A Top Investment Writer is Joining Josh Brown and Barry Ritholtz at Their Firm (Business Insider)
- One of Wall Street’s best-read bloggers is joining Josh Brown at Ritholtz (MarketWatch)
I know that’s not the point of the post, but anyway, the NASA story is bogus if only because using pencils in zero gravity is a very bad idea.
It’s a good example of Mencken’s quote “for every complex problem there is an answer that is clear, simple, and wrong”
Adres is correct, you fell for an urban legend to make your (excellent) point. Americans and Soviets actually did use pencils in space, before the “Space Pen” came around. Americans favored mechanical pencils, which produced a fine line but presented hazards when the pencil lead tips broke (and if you’ve ever used a mechanical pencil, you know that this happens a lot). That bit of graphite floating around the space capsule could get into someone’s eye, or even find its way into machinery or electronics, causing an electrical short or other problems. And if there’s one thing Houston didn’t need, it was more astronauts calling up with problems.
The Soviet space program used grease pencils, which don’t have breakage problems—to access more of the writing wax, cosmonauts simply peeled away another layer of paper. The problem with a grease pencil is that it’s imprecise and smudgy—it’s a lot like writing with a crayon. The peeled-away paper also created waste, and bits of paper floating around a Soyuz capsule were nearly as annoying as bits of graphite floating around an Apollo capsule.
The final mark against pencils has to do with fire. Any flammable material in a high-oxygen environment is a hazard, as we all learned after the terrible fire on Apollo 1. After that tragedy, NASA sought to minimize the use of flammable materials in space capsules—and every form of pencil (traditional, mechanical, or grease) involved some amount of flammable material, even if it was just the graphite.
By 1969, both the American and Soviet space programs had NASA space pens in space. The space pen was used on the Russian space station Mir in the mid-1990s.
Super interesting. Thanks for sharing this.
Good stuff. I’m surprised they didn’t cover this in The Martian. You a NASA buff?
When I was a kid I was a HUGE fan of space exploration (I guess that continues to this day). I remember with great clarity waiting up until late at night to watch the first man to ever walk on the moon in 1969 (I was 11 years old). I still have in my garage my newspapers that detailed the Apollo liftoffs, landings, and moonwalks. While the cold war and Vietnam were terrible, that period also had a lot of incredibly inspiring achievements going on.
I love the NASA example because it illustrates the multiple layers of complexity that is captured. The foundations that looked at the hedging approach had absolutely the right idea in mind (how do I avoid future disappointment in a truly scary time?), as did the astronauts who spent millions designing the pen. The problem came when that assumption came with strings attached – how much does that hedging strategy cost? Is the cost of designing that pen worth it compared to the potential problems that a pencil could case? What do you value – safety or convenience? Elegance vs comprehensiveness? Absolute return or the path you take to get there?
[…] Solutions shouldn’t be more complicated than necessary (awealthofcommonsense) […]
Does simplicity leverage opportunity cost? I buy an index fund, always eat salad at lunch, return to the same beach for vacation, etc so I don’t have to spend time on those things.
What was the incentive to the endowments? Action meant intelligence? It’s easier to try something and justify it than do nothing?
The people in the room weren’t all illogical, but in what ways was their system different from yours?
A lot of it comes down to career risk. They think they have to impress their investment committees so they try to justify their roles. Also, there is so much peer comparison going on that they’re always trying to one-up each other. Instead of focusing on their specific organizational goals and needs, they try to do better than the competition.
When given the decision of action vs. inaction, action will almost always win because they think that’s their job. Misaligned incentives, basically.
I agree that ‘overthinking’ can easily devolve into the Emperor’s New Clothes, wherever erudite and thinking are valued, i.e. large institutions. But I’m having some difficulty with the jump from the 1% hedging cost to the 4% annual spending constraint. The hedge is not for the 4%; it is for the 95% of the endowment.
We could say that we could avoid a tragic car crash by avoiding cars, and walking everywhere. Investing in good walking shoes is a lot cheaper than bleeding expenses like gasoline, maintenance, and depreciation. But the other things lost are the mobility, freedom, labor elasticity and productivity of being able to get to more places. And so, in addition to all the other expenses, the car owner would do well to buy insurance, for tail risk events like crashes.
My guess is that the endowment was invested in private equity funds, long-only funds, and alternatives–meant to yield closer to 10% per year. The downside of reaching for double-digit returns in this environment are the risk of market shocks. The tail-risk hedging was meant to offset larger, global shocks like the 2008-9 crisis. If the endowment cared about it’s risk-adjusted returns over the long term, it would do well to reduce the average volatility of its returns to the single digits. But it still needs positive returns, preferably double digit returns on average.
Sure, but they explicitly laid out the case that the point of the hedge was to make sure they didn’t have to touch the other 95% of the fund when things got bad. They didn’t want to have to sell down other allocations to hit cash flow needs.
Agreed. The hedge is for reducing the volatility of the 95% of the fund that is invested in riskier assets. There really is no hedge for cash or treasuries. They keep short term liabilities in cash and treasuries. My point was that if the endowment wants risk-adjusted returns, they will buy insurance that reduces volatility. The hedge doesn’t solve for their short-term liabilities, it solves for the risk proxy of volatility.
The payoff of the hedge is 4:1. Even if it has a positive expected value i.e. we are certain to have a crash in the next 4 years, therefore, the 4% return outweighs the 4 x 1% or 3×1% spent or 2*1% spent or 1×1% spent…The problem happens is that premium will increase following the event. so it may cost 2%.
Optionality is only good when it is mispriced.
Right. This was basically a case of closing the barn door after the horse already got out.
I’m not sure the payoff of the hedge is 4:1–where did that assumption come from? Referencing Kelly Criteria, there are three numbers we are concerned about: the probability of win vs. loss, and the payout of the win, and the payout of the loss. Using hypothetical numbers, if a tail risk event probability is 1% and the payout of the of the insurance is 15:1, we still need the payout is if there is no tail risk event over the expected investment horizon. If the payout is of the latter is sufficiently small, it makes sense to buy the insurance.
[…] Why do institutional investors typically default toward complexity? (awealthofcommonsense) […]
Very interesting post as usual.
Very often complexity is introduced into systems because operators would like to optimize or maximize. Often, though, with a “good enough” system you can reach all the low-hanging fruit and you may find that the high-hanging fruit are not worth the extra costs. .
That’s very true. It’s just so hard for many to accept good enough.
This is my favorite post you’ve written in 2015. Profound.
As I learn more about diversifying my cash across various subclasses of stocks, I’m tempted to jump into the StockTwits/Twitter world of picking companies. But after a long look, things just seem 5000 points of complication for an extra 500 points of yield (and 1000 points of yield). Why not just stick with the diversified/rebalanced basics and have a vast larger pool of hours in my day to focus on the things that give me joy and life?
Figuring out your own strengths and weaknesses is half the battle. The fact that you have that figured out is huge.
[…] Complexity as a Default: awocs […]
[…] Complexity as a Default […]
[…] you had that sinking feeling that you missed the trick the examiner had laid out for you – Complexity as a Default. This can also apply to investors, trying to make things simpler is normally […]
I’m generally a fan of your writing Ben, but in this case I think you miss an important point. The hedge cost as compared to the spending need is not really the point. The hedge cost vs the expected return from the hedge is what is of concern. If a tail risk event is expected even once in the next 25 years, let’s say, and is expected to result in a drawdown of 25% of the overall portfolio (a loss of $2.5 billion), then the hedge will have roughly paid for itself. More frequent tail risk events will mean a win from the hedge, less frequent events will mean a loss from the hedge. This is simplistic math, and much depends on the actual behavior of the hedge vs the markets which is highly uncertain, but the problem can be viewed constructively in this way. The real problem with this tail risk hedge approach is the uncertain nature of the hedge performance, and the general inability for anyone to predict when the next event will occur. It makes much more sense for the managers of an endowment, to focus on the overall costs of the portfolio and how much volatility they can bear from traditional asset classes, and then tailor the portfolio in a way where they can meet their spending needs nearly regardless of market performance. After all, endowments are nearly the epitome of what should be considered long-term investors. They can, and should, ride out market volatility with an approach geared to containing costs and expecting reasonable returns.
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