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Confessions of a Money Manager: Simplicity is a powerful tool for portfolio management

Ray Unger  —  8/14/2008 6:06 pm

Is Ockham's razor some sort of newfangled shaving system? No, it's a pragmatic approach to explaining how things work, particularly how scientific phenomena can be explained. Although not directly related to business, Ockham's approach has great applicability to investment strategies and portfolio management.

Wikipedia tells us that William Ockham (c. 1285-1349) was an English logician and Franciscan friar who espoused a nominalist's insight on solving complex scientific problems. The Latin maxim attributed to him, Entia non sunt multiplicando praeter necessitatem, is roughly translated as, "Entities should not be multiplied unnecessarily." Others have paraphrased his dictum as: "All things being equal, the simplest solution is the best."

As I get older -- and hopefully wiser -- I've learned to appreciate this notion of simplicity. It applies to our lives as well as our investments. As we attain wealth, we gradually acquire things that we think will enhance our lives. Later, we find that these life-enhancing acquisitions do the reverse -- they complicate our lives as we become slaves to their collective maintenance. Second homes, boats, club memberships, season tickets, and other acquisitions that require increasing amounts of time, effort, and money often make life more complicated than necessary.

The same applies to investing. Gradually, as we attain wealth, we invest in things piecemeal ignoring the cumulative effect of how such investments not only complicate the portfolio, but render us virtually helpless in understanding what we own.

What prompted me to think of Ockham's razor was the late Tim Russert's autobiographical book, "Big Russ and Me." Since Russert's father was also named Tim, the family differentiated the elder from the younger with the nickname Big Russ. Well, Big Russ was a blue-collar sanitation worker. Nonetheless, he instilled in his son valuable life lessons and was a tremendous role model for the eventual host of television's premier news show, "Meet the Press." One of those life lessons was his simplistic way of understanding finances. When a suitor asked Big Russ if he could marry his daughter, Big Russ asked him how he was going to support her. He then offered the suitor a single sheet of paper, and a pencil and asked him to explain his plan "so that I can understand it."

Ockham's razor is the more formal maxim that Big Russ used, and here is how such principles apply to managing our investments.

First of all, always look at any prospective investment as an addition to your total portfolio, and ask yourself: "How will this benefit or affect the total portfolio?" You'd be surprised how often pending investment ideas are rejected when asking this question.

We see a lot of portfolios from prospective clients and just shake our heads. For example, we saw a portfolio valued at a mere $20,000 that included some 10 to 12 individual stock positions. We were then told by the prospect that the broker routinely turned over the portfolio many times each year. Now that's something that Ockham's razor would instantly cut off.

We've also seen portfolios with some 25 to 35 mutual fund positions. On one particular portfolio, the dollar amounts of each position were coincidently just below the breakpoints for commission discounts. When we reviewed the mutual funds internal stock holdings we found that most were pretty similar. Now some investors may think having 25 to 30 mutual funds represents diversification. Unfortunately, when they're all alike, they perform in tandem with the Standard & Poor's 500. That being the case, Ockham's razor would cut that back to one mutual fund: an S&P 500 Index with a tiny management fee and no commission.

We also see portfolios, including qualified retirement accounts such as pensions, and IRAs, that hold all manner of insurance products and annuities. When asked about these, the investor usually says something like: "I knew the reason I bought it when I bought, but I can't recall why right now."

In essence, using Ockham's razor for managing investments means cutting off those extraneous elements of a portfolio that either don't add value or cost too much to maintain. And if investors can't decipher what they have, that alone should spark them to dig for the reason, and then apply Ockham's razor.

Ray Unger is chairman of Forward Investment Advisors in Madison. He can be reached at 833-9400.

Ray Unger  —  8/14/2008 6:06 pm