Better Results Via Simplicity
As this semester sped along, I received a call from my nephew, Ryan. He graduates in May with a finance degree from a respected mega-university.
He was neck-deep in a “financial modeling” class and asked if I’d review his semester project. It was a spreadsheet more than 750 lines deep. It was full of macros, pivot tables and limitless assumptions.
As I perused my nephew’s work, I remembered a quote from an investor who said, “If your answer takes until line 350 of a spreadsheet, you are making it too hard.”
Although financial models can be very useful, they can also be deceptive. Often, the longer the spreadsheet, the more variables which must be properly assessed. A small error rate compounds geometrically over time resulting in false precision.
At past Berkshire annual meetings, Warren Buffett and Charlie Munger have been asked why academic programs don’t teach finance and investing the way they do. Munger has tersely replied that if they focused on things that truly matter, universities and textbook companies would not have the volume of material to teach or books to sell.
Financial motivation leads me to believe that many experts feel compelled to deliver reams of data and books of analysis to justify fees—regardless of the results. Can you imagine the look on a big client’s face when presented with a $100,000 fee but only one sheet of paper with a concise and effective answer? Rather, volumes of pages, graphs and charts typically accompany the six-figure fee, even if the answer is less effective. Complexity and opaqueness sells consulting services and promotes academic literature.
When I was in graduate school it was common for consultants and academics to develop incredibly complex models. They would triumph that their particular model had a 92% accuracy rate, or some similar claim.
What they later found was that in chasing money or bragging rights the experts added so many variables to a given model it was hard to know which variables truly mattered. As such, efficacy was lost.
A good example of this complexity was in 1998 when Long Term Capital Management imploded. With two Nobel prize winners on their team, they certainly had the smarts. However, their models were incredibly complex with a long line of inter-related variables. Making matters worse, they used tremendous amounts of leverage.
LTCM had over $120 billion of assets when it cratered. However, due to borrowed money its credit exposure was so enormous that the Federal Reserve was forced into action to prevent a broader collapse.
Buffett has often said if you have a business to sell, he can tell you whether he is interested in five minutes. That statement used to confuse me. However, in studying his methods one realizes Buffett has filtered every possible question that could be asked, into the few that truly matter.
Buffett knows that in providing downside protection a simpler model allows you to build a wider margin of safety. This allows him to be “approximately right as opposed to precisely wrong.” Again, the greater the complexity, the more variables. This makes it geometrically harder to build a true safety cushion.
In addition to knowing which variables matter, Buffett puts the odds in his favor by extending time frames. Even if your models and assumptions are 100% accurate, it does not mean the markets agree with you. However, the longer you extend your time frame, the higher the odds are that the market will come to appreciate the wisdom in your analysis.
When I look at our best investments this year, it is easy to puff out my chest and look smart. However, truth be told, those same “best” investments were our worst investments last year. Being patient allowed them to perform as expected.
As you build your own financial models, budgets or projections, know the top five or ten variables or questions that really matter.
Summarize your investment thesis in one page or less and then look in the mirror. Are you making it too hard? Are you being intellectually honest?
Be careful with leverage. Borrowed money makes us look smart when the market agrees with us. However, it is wickedly painful when the market disagrees.
Give your investments enough time to succeed. The dividing line between bum and hero can be mere days, weeks or months. Why leave it to chance? Give your portfolio at least ten years to achieve maximum success.
Dave Sather is a Certified Financial Planner™ and owner of Sather Financial Group. His column, Money Matters, publishes every other week.