Keep it simple, stupid – because degree of difficulty doesn’t count

The Kiss approach – keep it simple, stupid – has merit in many fields, not least in that of investment, where complexity and seemingly sophisticated strategies don’t always yield the desired results.

Take hedge funds, which have underperformed stock markets for each of the last five years. The performance gap is alarmingly large at this stage.

On average, hedge funds have underperformed the S&P 500 by more than 62 per cent over the period, the Financial Times reported earlier this year, and have trailed EAFE, an index of developed world stocks outside the US, by almost 27 per cent.

Hedge funds point to a strong global bull market, and argue their job is to manage downside risk. Given their infamously high fees, one might expect excellent risk-adjusted returns.

However, the ultimate no-brainer asset allocation strategy – a 60:40 allocation to stocks and bonds – would have outperformed hedge funds every year since 2002, according to Simon Lack, author of The Hedge Fund Mirage .

The Kiss approach is also advocated by Warren Buffett, who has left instructions in his will for 10 per cent of his money to be put in short-term government bonds and 90 per cent in a low-cost S&P 500 index fund. In 2008, he bet $1 million (€720,018) that hedge funds would not outperform the S&P 500 over the next 10 years. His million dollars looks safe – six years on, the index is handily beating the hedge funds.

By simply sticking to low-cost index funds, the "know-nothing investor can actually outperform most investment professionals", says Buffett.

Beating the market
Given so few investors beat the market, it's ironic that long-term outperformance has been generated by the simplest of strategies.

The Dogs of the Dow strategy, which simply buys the 10 highest-yielding Dow Jones Industrial Average stocks each January, easily beat US indices over a multi-decade period.

Studies have also found outperformance in Finland, China, Thailand and, spectacularly so in Japan, where returns averaged 13.6 per cent between 1981 and 2010, compared to 3.97 per cent for the Nikkei.

Rory Gillen, co-founder of Merrion Capital and now running GillenMarkets.com, is also a fan of simple dividend strategies. Between 1995 and 2011, he found, picking the 15 highest-yielding stocks in the FTSE 100 returned 11 to 12 per cent annually, compared to 7.4 per cent for the FTSE 100.

This simplicity – forget the news and painstaking analysis, just buy a basket of stocks and juggle around once a year – means many may be instinctively suspicious.

However, the outperformance is no fluke, says contrarian investor David Dremen, who argues high-dividend stocks tend to be out-of-favour firms driven below fair value.

He likens the continued outperformance of value strategies to a casino, where you are shown a red door and a green door.

Those in the sparsely attended green room grow their cash pile, while those in the red room gradually lose theirs. And yet, the lure and excitement of the red room proves too much, drawing you in against your better judgment.

Value investors looking for an edge of 10 refer to Buffett's mentor, Benjamin Graham, who detailed his investment philosophy in books such as Security Analysis (1934) and The Intelligent Investor (1949).

What’s less known, however, is that, prior to his death in 1976, Graham dismissed “elaborate techniques of security analysis”, saying they were unlikely to be worth the hassle any more, given increased market efficiency.

Instead, he recommended a "highly simplified" approach, one using one or two criteria to assess if value was present, and to rely on the performance of the portfolio as a whole rather than examining individual stocks.
Buy cheap
The number of simple market-beating value strategies confirms this view. Dublin-based Covestone Asset Management, for example, has found the cheapest decile of global stocks outperformed the most expensive by almost seven percentage points annually since 1990.

In Europe, the cheapest 20 per cent of stocks based on cash flow yield enjoyed excess returns of 0.78 per cent per month since 1990; the cheapest based on price-earnings ratios beat the market by 0.41 per cent per month; the cheapest based on price-to-book value and dividend yields recorded excess monthly returns of 0.29 per cent and 0.28 per cent respectively.

A simple, systematic approach is also recommended by money manager Joel Greenblatt, who uses basic criteria such as earnings yields and return on capital to look for cheap, quality companies. Buying a basket of such stocks, and rebalancing occasionally, has resulted in massive outperformance over the years.

This basic “buy cheap” approach also works for international stock indices, using cyclically adjusted price-earnings ratios (Cape). Cape averages earnings over a 10-year period. You rotate into indices with low ratios, and out of those with high ratios.

Again, it may sound too simple to be very useful, but 20-year US returns have averaged 13.4 per cent annually for investors who bought when Cape readings were at their lowest, compared to just 3.2 per cent when Cape levels were at their highest. The picture is a similar one for other international indices.

Information obsession
The evidence, as analyst James Montier notes in his classic paper Seven Sins of Fund Management , confirms that investors should focus on a "few important factors". Instead, investors tend to be "obsessed by information", spending "countless hours trying to become experts about almost everything".

A number of studies confirm that more information doesn’t necessarily indicate better information. Montier cites one study where a group of MBA financial students were asked to forecast quarterly earnings based on the last three quarters of earnings, sales and the company’s stock price. Another group were given the same information as well as some new, additional information.

“Just the presence of extra information (be it useful or not) was enough to significantly increase the error rate of forecasts,” says Montier.

In another study, participants were asked to estimate the following day’s demand for ice cream, and given either one useful signal or three useful signals. The group with three signals were less efficient in processing the information, Montier notes, and made worst forecasts.

In a third study, bookies were asked to select information that would help them work out the odds on a horse race. They were then given increasing amounts of information. Result?

“All that happened was the extra information made the bookies more and more overconfident without improving their performance at all.”

Furthermore, the more variables introduced into an investment premise, the more frail its foundations. It may sound impressive to hear an analyst make an economic forecast, predict the path of interest rates, how that will favour certain sectors and how that will impact on certain stocks. As Montier points out, however, even if his forecasts are right 70 per cent of the time (way above rates actually seen), the odds of getting all four forecasts correct are just 24 per cent.

Analysts’ predictions, of course, are based on forecasts relating to sales, costs, margins and innumerable other items. Their very complexity dooms them to fail.

Punitive types might see the Kiss approach as in some way less honourable. However, investors “should remember that their scorecard is not computed using Olympic-diving methods”, as Warren Buffett once quipped. “Degree of difficulty doesn’t count.”