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Investor Psychology

Keep Your Investing Simple

Markets are complicated, so we often rationalize that a complicated strategy is necessary to beat them. That logic is faulty.

There are more than 8,100 mutual funds in the U.S., some 1,500 exchange-traded funds and just over 4,300 stocks listed on U.S. exchanges. Roughly $40 trillion worth of bonds trade here. Then there are options, futures and other derivative securities (credit default swaps, anyone?)—and let’s not forget variable annuities and other insurance products. When you consider that there are countless ways to combine these and other investment vehicles in an infinite array of strategies, it’s clear that investing can get very complicated very quickly. And that’s a problem.

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As investors, we have a hardwired preference for complexity, says Jason Hsu, cofounder of Research Affiliates, a Newport Beach, Calif., firm that specializes in investing using indexes that are tweaked to maximize returns. Markets are complicated, so we often rationalize that a complicated strategy is necessary to beat them. That logic is faulty. Research shows that simple strategies with minimal trading perform about the same as more-complex, high-turnover strategies—until you add in the fees. Then, simplicity, which is often less expensive, has the edge.

Most investors will delegate the management of complex investments to a pro—an adviser or a mutual fund manager to whom they attribute more acumen than perhaps they should. Your inner voice tells you that the person does something you don’t understand, and because you’re no dummy, that person must be a big expert. When the complicated investment goes south, the natural instinct is to blame the manager, who obviously has lost his or her touch and needs to be replaced. Then we compound our error by firing the manager and looking around for the next complicated, expensive scheme. “Complexity tends to lead to more delegation, and once you delegate, you see a lot more rapid hiring and firing,” says Hsu. That’s often what accounts for the gap between what an investment returns and what investors actually earn, he says.

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Just hang on. Interestingly, when people make their own investment decisions, they’re less likely to cut and run. There’s a natural tendency toward overconfidence in something we’ve researched and chosen. When it doesn’t perform, it’s the market that’s irrational. A desire to avoid realizing losses keeps us holding on. “A desire to not fire yourself has a positive effect,” says Hsu. “You’re more able to be a buy-and-hold investor. As long as you’re not in something fraudulent, buy and hold generally leads to a better outcome than rapid buying and selling.” He adds one caveat: “Complex products are often expensive, with layers of fees on fees. Buying is a bad idea, and holding on for a long time is a horrible idea.”

There’s another problem with too much complexity, says Harold Pollack, a University of Chicago professor who gained renown for his assertion that everything you need to know about personal finance would fit on an index card—and then coauthored a recently released book about it (The Index Card: Why Personal Finance Doesn’t Have to Be Complicated). “The hidden cost of complexity is that it ties up too much cognitive bandwidth,” he says. Unless your situation itself is complicated—you’re juggling stock-option grants with the risk of being over-invested in your employer, say—Pollack says most people will do just fine with something along the lines of a target-date fund, or index funds that they don’t think about more than once or twice a year when they rebalance.

So skip inverse leveraged ETFs and other investments of that ilk. Devote your efforts to the things you actually have control over, such as doing a good job at work, formulating a livable budget and setting up a consistent savings plan.

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