Occam’s Razor on Investing
When two competing investment theories are presented with no definitive proof of which is better, the simpler one is better.
There are two competing investment theories – efficient markets and inefficient markets. The first proposes that financial markets efficiently price securities and that trying to beat the markets does not work in the long-term. The second proposes that market prices are often wrong and that it is possible to consistently outperform by uncovering and exploiting this mispricing.
If you believe in efficient markets, then you’re likely an investor in a diversified portfolio of low-cost index funds and you won’t attempt to time markets.
If you believe in inefficient markets, then you’re likely an investor in actively managed strategies that attempt to exploit market inefficiencies and you may try market timing.
Which should you choose?
In truth, both theories are relevant. Market efficiency appears to be generally true for most people although there are examples where people have consistently exploited pricing inefficiencies in the past. That being said, there is no guarantee that inefficiencies will persist in the future or that that same people will be able to exploit them.
“This decade is strewn with examples of bright people who thought they had built a better mousetrap that could consistently extract an abnormal return from financial markets. Some succeeded for a time. But while there may occasionally be misconfigurations among market prices that allow abnormal returns, they do not persist.”
Inefficient market advocates say there are ample opportunities to exploit markets over the long-term and point to Warren Buffett as proof. This is true, but naming a few examples doesn’t make it true for everyone.
If outperforming the market was easy, why is it that most professional portfolio managers can’t do it? There is abundant performance data available on mutual funds, pension funds, endowments, and individual investors that point to the inability for most to match the performance of the markets ̶ let alone beat them. See The Power of Passive Investing for a composite of these studies.
The probability of outperforming the markets is small, and the payout for being right is often lower than the potential shortfall from being wrong. The cost to try to beat a market is considerably higher than holding a low-cost index fund that matches a market’s return. In addition, active strategies are always more complex than a passive index fund strategy. This makes active management an inefficient way to invest.
Yet, beating the market has been before and it will be done again. Will it be done by you? That’s probably the wrong question.
The right question that all investors should ask is this, “Which investment strategy provides me with the highest probability to reach my financial goal?”
With this question in hand, we can seek help from a 14th century logician and Franciscan friar William of Ockham. He was a major figure of medieval thought and was at the center of the major intellectual and political controversies.
Ockham is best known for Occam's razor (also written as Ockham's razor), a principle for decision-making that stems from logic. In its simplest form, the principle states that among competing hypotheses leading to the same outcome, the one that is the simplest should be selected.
There are many variations of Occam’s razor. It has evolved over the years to fit different circumstances, including my own version about investing in the opening sentence.
Here’s how Occam’s razor fits into investment decision making. Assume the markets are neither entirely efficient nor entirely inefficient. Thus, active management and indexing are expected to lead to the same result. Which should you chose?
The answer is index investing. In my opinion, it is the simplest, clearest, cheapest, and most efficient method for achieving the desired result ̶ which makes it Occam’s razor solution to investing.
I am certain that William of Ockham would have been an index investor if he had the chance. This assumes the expected results of active management and indexing are the same. The fact is that active investing doesn’t match the results of indexing and that makes the case for indexing even stronger. A portfolio that holds only low-cost index funds has a higher probability for reaching your financial goals.
The answer is all index funds, all the time, held in a stable portfolio based on your needs. I am sure William of Ockham would have agreed.