Ockham's Razor and the Illusion of Complexity
A 14th century Franciscan friar, William of Ockham, is credited with having formalized the principle that "simpler solutions are likely to be more correct than complex ones." Also known as the law of parsimony, this "keep it simple" concept is often referred to today as "Ockham's razor" – a tool to be used in cutting away extraneous material when getting from point A to point B.
A great read illustrating how this concept applies to investing can be found in John Watkins' article The Illusion of Complexity, published recently by the Hilliard Lyons Trust Company.
Acknowledging the growing complexity of the world in which we live and of financial markets, Watkins writes, "A typical response is to fight complexity with complexity. Many investors believe they need investment solutions that are complex... and hyperactive."
"Simple is often confused with 'easy' and complex is confused with 'sophisticated'," writes Watkins.
What Would Wile E. Coyote Do?
Most of us can recall the amusingly unfortunate outcomes of elaborate plans made by various Saturday morning cartoon antagonists. But even without that context it seems a little ironic that the investment industry's response to intense market disruption or protracted uncertainty often involves additional layers of complexity.
A case in point: Bloomberg's announcement during last year's stock market correction that "UBS Global Wealth Management is embracing a playbook beloved by hedge funds – a slew of options trades" purporting to be "the skeleton's key to unlock ever more complex and fitful markets."
Contrast this with Watkins' overarching investment philosophy: "We believe that simplicity, rather than complexity is the best way to achieve long term investment objectives."
The Strength of Simplicity
On one level, Ockham's razor is trivial. Of course the solution with the fewest moving parts will have the highest utility value. But on another level, it is deceptively profound. That's because the characteristics of simplicity and complexity are integrally related to resilience and fragility.
As Nicolas Taleb explored in his book, Anti-Fragile, complex structures and complex systems, whether natural or man-made, are inherently fragile. When subjected to shocks or stress, they tend to break more easily, the breaks tend to be more damaging, and the damage tends to be more permanent. By contrast simple structures and simple systems have a much greater capacity to withstand turbulence multiple standard deviations away from the norm. Think, for example, of the difference between how trees in a forest and downtown office buildings are affected by earthquakes.
The financial crisis gave us a test case of just how fully this link between complexity and fragility applies to our modern day financial system. Most of the devastation during and after 2008-2009 was caused by complex financial products – like collateralized mortgage and debt obligations – and the most serious breakage occurred at complex organizations like Lehman Brothers and AIG.
The Devil in the Details
Complexity is also inversely related to transparency, Watkins points out. Complex investment solutions are harder for investors to understand. It is harder to predict how they will respond under extreme conditions. And it is harder to know what to do when they deviate from expectations.
Warren Buffet's longtime partner at Berkshire Hathaway, Charlie Munger, has been quoted as saying, "Simplicity has a way of improving performance through enabling us to better understand what we are doing."
For Watkins, the benefits of simplicity are equally fundamental: "Simplicity is the cornerstone of intelligent investing."
While on the topic of transparency, I will disclose here that John is one of many seasoned investment professionals at Hilliard Lyons who will be joining Baird next month. And I couldn't be happier about that.
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6 年Indeed!
Sorry, the post badly misrepresents what William of Ockham said. It's a wishful reinterpretation, very much colored by modern attitudes, that gets spread as a meme without anyone bothering to check the source -- or even Wikipedia. The process is the same as spreading any other ignorant falsehood via a platform like Facebook. Though here on LinkedIn the managerial class is supposed to be wiser than the masses at large.? The writings of William (BTW 'Ockham' is the name of the English village where he was born, and the spelling 'Occam' is from the Latin version of that place name) date from the early 14th Century. He ?didn't talk about "solutions" or likelihood. There's almost no statement of his "razor" in his works. Maybe the closest is in Summa logicae, I.12, where he analyzes the process by which the mind comes to understand something. He mentions various contrasting opinions, and explains that those who favor a simpler explanation do so on the grounds that "it is vain to do by means of many things that which can be done with fewer" (Frustra fit per plura quod potest fieri per pauciora.) ?In context, you could even argue that he's not necessarily endorsing this principle, but just saying that those who hold a certain opinion about how the mind works justify it on the basis of the principle. (A bilingual version of his original text (Latin-English) is available online.)? Wikipedia also attributes another formulation to William, but I couldn't find any citation for it.?To the extent his own philosophical method illustrates the use of the razor, this seems to have been limited to a pretty abstruse matter of Aristotle's philosophy of ontology. See the Stanford Encyclopedia of Philosophy entries for "William of Ockham" and "Simplicity," especially § 2 of the latter.? In the example given in the SEP, this involved an explanation with fewer "entities," a term that has a very specific meaning in the Aristotelian context. This also led to the better-known 17th Century summary of his principle, "Entities should not be multiplied without necessity" (Entia non sunt multiplicanda praeter necessitatem). No matter how you slice it, though, what William was talking about was how you *explain* something: if you've got several competing explanations for something, where each of them explains the thing you're trying to explain, the explanation that's simpler in some way is better. He never proposed it as a principle for deciding how *to act.* So how does this connect to investment? Investment isn't about explanation -- it's about forecasting and gambling. This is action, not explanation. Moreover, you can't be sure you'll get a particular return when you invest. So if you have several different possible investments, you can't be sure any two of them will give you the same result. So you can't even argue that the simpler strategy is a simpler "explanation" of the same financial result.? The bigger point, though, is that with Wikipedia and a little thinking, anyone in this thread could have found that the connection between Ockham's razor and investment decisions is bogus. You don't need to know Latin or anything so rarefied. How many of you would get annoyed at an employee who assumed facts he or she could have seen were wrong just by using Wikipedia or a search engine? How many of you would say that intellectual laziness and lack of curiosity is a good qualification for management, or for being an investment officer? Forget the razor -- look in the mirror.
ASL/English Interpreter
6 年By the way, it's "Occums Razor"...