Hi Guys,
Today, I came across an article that discussed Occam's Razor. I believe that simple is always better than complex when options exist. Here is a Link to that article:
https://www.farnamstreetblog.comI expected that the article would investigate Occam's Razor's application to investing. I was wrong. However, I did recall earlier articles that did address its application to the investment world. A quick web search uncovered the following piece by Rick Ferri. Here is the Link to the Ferri work:
https://www.forbes.com/sites/rickferri/2013/03/07/occams-razor-on-investing/#c1ae17e58ab2Please give it a read. It concludes with a useful observation.: "index funds has a higher probability for reaching your financial goals." Wise words!
The emphasis is on "probability". There are no certainties when investing. We operate in a world of uncertainties so the key is to select the option with the highest expected return. I'm using expected return as the probability of a successful outcome times it's likely payoff.
Enjoy the references and good luck.
ADDED THOUGHT: Since we are talking probabilities, we benefit greatly from diversification. It's prudent policy to not bet too much on anything. Make many (like 10 or more) uncorrelated bets.”
Best Regards
Comments
When MJG writes: "the key is to select the option with the highest expected return", he is saying that different options have different outcomes. The conclusion is that we can't use Occam's razor.
Ferri writes, on a leap of faith as near as I can see, that "active management and indexing are expected to lead to the same result. Which should you chose?" This is how he rationalizes using Occam's razor.
Yet at the same time, like MJG he also that the expected returns are different: "The probability of outperforming the markets is small, and the payout for being right is often lower than the potential shortfall from being wrong".
IMHO, pseudo-logic babble.
An example of how to use Occam's razor: If you had no data about motion close to the speed of light, you would look at Newton's laws of motion and Einstein's theory of relativity, and conclude that Newton was right. Force equals mass times acceleration. Clean and simple, and it predicts all normal speed motion the same as relativity does.
That would be the wrong conclusion, but if you can't tell the difference, Newton's laws work just fine and they're easier to work with. They've held up fine for hundreds of years. But if you had measurements on motion near the speed of light, you'd find that Newton's laws predicted different (and wrong) outcomes. In that case, Occam's razor wouldn't even come into play, because the two theories of motion wouldn't be predicting the same results.
It would be nonsense to suggest applying Occam's razor here.
Regards,
Ted
Thank you for your comments.
Simplification serves as a terrific guiding principle, but it definitely has its limits. As Albert Einstein said: "Everything should be made as simple as possible, but not simpler."
Einstein's qualifier that ends the quote is a critical constraint that each of us applies differently. It is often a challenge to judge when oversimplification might lose important aspects of a problem. The risk that one investor finds acceptable possibly is flatly rejected by another investor. That's what allows a marketplace to function.
I used expected return as a candidate model without specific numbers. For example, suppose one attractive investment had a 10% chance of success with a likely return which translates to an expected return that doubles the investment. Say an alternate investment had a 50% chance of success, but only a more modest likely return increase. That second investment has a lower expected return at a lower risk level. A decision tradeoff exists. That's common in the investment universe.
The investor now has a difficult but simple choice that is a tradeoff between risk and reward. Everyone will do that tradeoff with his own special spin that reflects many variables such as time, circumstances and needs.
Occam's Razor is not necessarily easy to apply. Simple doesn't always translate into easy in the decision making world. But simple is usually a better and more understandable decision in most instances.
Best Wishes
Thanks for your participation.
Although I was never a true politician, during the late stages of my career I was frequently tasked to prepare replies to government Requests For Proposals. Even when I disagreed with the work statements, I learned to respond in a manner that did not attack the sagacity of the statements. Although we lost many Proposal Requests, we did win a sufficient number to be fully funded at all times. That's a success story itself!
I'm a dedicated believer in Occam's Razor. We tend to complicate matters frequently by changing what should be linear matters and simple decisions into nonlinear problems that defy easy solutions. That's a common mistake that can be avoided.
Of course, all coin tosses have two possible outcomes. As Steve Covey noted:"While we are free to choose our actions, we are not free to choose the consequences of our actions,". We should never allow our decisions to be infected with false confidence of success. Unwelcomed surprises happen. Diversity is a big help in diffusing bad outcomes.
Best Wishes