As the Dow crosses another arbitrary round-number milestone of 17,000 today, many investors will feel the need to do something, anything, in response. A great column today by Morgan Housel discusses the importance of simplicity and restraint. Housel explains that following simple rules of thumb is usually more effective than a more complex and active approach. He illustrates the point with a great baseball analogy:
Take a look at this baseball player. He’s doing something extraordinary.
A ball was hit a few hundred feet away, coming off the bat at about 90 miles per hour. In less than five seconds the outfielder ran to the exact location the ball landed, down to the centimeter, catching it without a blink to spare.
This is extraordinary because of what he needed to figure out in those five seconds. He had to know the ball’s initial velocity, spin, and angle. He had to know the exact speed and direction of the wind, since it would alter the ball’s trajectory. He had to know exactly when the ball would switch from vertical ascent, lose speed, stall for a moment, and begin its decent. The calculation necessary to know where a ball will land is a monster:
This is nearly impossible to calculate in your head. Yet players do it all summer. According to Inside Edge, 84.7% of baseballs that hang in the air for five seconds end in an out. Stephen Hawking could not calculate this equation in five seconds, but Lenny Dykstra did thousands of times.
. . .
Markets are endlessly complicated, investors are endlessly emotional, and there are no points awarded for difficulty. Overthinking things like valuation and modern portfolio theory can be the equivalent of a baseball player pulling out a calculator after each ball is hit, desperately trying to track its landing point with precision. Any time you can tame a complicated system into a simple rule of thumb, you will be better off.
This is not to say that we ignore altogether the more complex aspects of investing. We spend a lot of time studying valuation, stock analysis, portfolio management and technology. But you have to take any complexity and innovation with a grain of salt. As I wrote last week in my post about narrative and numbers in valuation, complex formulas can mislead you with a false sense of precision and objectivity like the baseball player with the calculator. In our experience the simplicity and restraint of following rules of thumb usually trumps complex formulas and active trading in the long run.