The power of simplicity

Einstein, who gave us that exquisitely simple and beautiful formula e=mc2, ranked simplicity higher than genius. Henry David Thoreau, the 19th century American writer cum philosopher, once said: “Our lives are frittered away by details...Simplify, simplify.” Edward de Bono, the world's foremost living authority on thinking techniques, has written an entire book titled Simplicity.

In life most of us don't adequately appreciate the power of simplicity. We are often enamoured of the ornate, the convoluted, and the obscure. Perhaps our education, which subconsciously instils in us respect for the complicated and the arcane, is to blame. It is only after we experience life at close quarters that we once again acquire the confidence to appreciate the beauty inherent in simplicity.

As in life, so in the world of investment, simplicity can be a powerful weapon. First, it helps you avoid mistakes. In investing, mistakes cost you twice over. They cost you not just money but also time - time in which a better-constructed portfolio would have compounded and grown. And second, if you pledge to yourself that you will not invest in anything that you don't understand, you will save yourself a heap of money and trouble.

First steps. If you are an absolute beginner who knows nothing about investing, here is a rudimentary financial plan that you could use to start off with.

First, build up some liquid reserves for an emergency. This should equal at least three months' (ideally six months') salary. Keep this in your savings account or in a liquid fund. As a second line of protection against contingencies, take a credit card. But use it only during emergencies.

Next, invest in a fixed-income instrument such as the Public Provident Fund (PPF). Its assured 8 per cent return will lend stability to your portfolio. You may have a reservation about the lack of liquidity during the first five years. To overcome this hurdle, begin investing in PPF as soon as you start a job. Make small contributions at first. This way you will be able to cross the period of illiquidity before any major responsibilities (requiring a withdrawal) arise. Once the period of illiquidity is over, raise your contributions. If an emergency does arise during the first five years, you can take a bank loan using your PPF deposits as collateral. The PPF investment will also take care of your initial tax-saving needs (if any).

Next, invest in equities to make your savings grow at a fast trot. Begin by investing what you can spare for the long term (five years or more) in an index fund. Besides the advantage of low cost, these funds are especially suited for beginners because they require no monitoring. Unlike an actively-managed fund, here you do not have to worry about performance going for a toss: you will under all circumstances get the return that the market index earns.

Split your investments in the index fund and PPF in the ratio of 80:20 (if you think you can take more) risk and 70:30 if you are of a conservative bent.

Next, even though your office may be offering you a health insurance cover, supplement it with one of your own. And if you have dependants (who would be adversely affected in case of your sudden demise) buy a term insurance cover.

Obstacles. If you implement this simple and basic financial plan, you will be off to a great start. You can build upon it later as you earn more, and learn more about investing. But let me warn you against a few impediments. One is misleading intermediaries. A relative of mine, whom I persuaded into buying a health insurance plan, has still not been able to buy one a year later. The reason: though he specifically asked for a mediclaim policy, he was once sold a Ulip with a critical illness rider and another time a hospitalisation benefit policy. Hopefully, he will get lucky the third time around.

Two, you could fall into the complexity trap: “If the plan this writer is suggesting is this simple, it couldn't be all that great, could it?” In which case all my advocacy of the power of simplicity would have been in vain.

The role of chance
Luck plays a greater part in life and in the markets than we ascribe to it
All of us intuitively understand the role of chance and luck in life (the Hindi word tukka has just the appropriate onomatopoeic ring to it). Napoleon said he preferred lucky generals, realising how the outcome of a battle depended on a single fortuitous turn of events. The Bible too acknowledges the role of chance. “I returned, and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all,” it says.

Some arenas, such as financial markets, have a higher degree of randomness. Chance plays a greater part in them. It stands to reason that if you are going to enter the markets, you should learn something about randomness from a maestro who has done some hard thinking on the subject. Nassim Taleb's Fooled by Randomness is just the right book for such an education.

It is not Taleb's contention that all success is the result of luck; knowledge, hard work, and perseverance too play a part. But chance plays a more important part than we give it credit for, he says. When a fund manager fetches a great return one year, the media lionises him. New money pores into his fund. Most investors act on the premise that if the fund fetched fabulous returns, it was owing to the fund manager's skills. Seldom do we think that it may have been the result of chance. Human nature being what it is, great performance is always attributed to one's skills. The fund manager creates a plausible-sounding story of the well thought out moves he made, and how they fetched him success. Alas, life being a great leveller, a great run of luck sooner or later comes to an end. If the initial performance was a flash in the pan, then the fund's performance inevitably declines. Does the same fund manager then attribute his poor performance to lack of stock-picking prowess? No way. Failure is inevitably attributed to bad luck. Taleb dwells on a concept called “alternative histories”. This refers to our tendency to get enthralled by positive outcomes with massive payoffs while ignoring the other less desirable outcomes that could have occurred with equal probability. For instance, before investing in a high-performing mutual fund scheme, an investor looks at its past returns. The mental picture he then draws is a straight line that projects past returns into the future. A more realistic mental picture would be that of the many tributaries into which a river splits close to a delta. If he thought more probabilistically, he would realise that a range of outcomes is possible: returns could be better than in the past, in line with the past, or worse.

Taleb asserts that in judging performance in any field, not just the outcome but the process should also be evaluated. A mutual fund scheme may have generated a great return. But if the fund manager took too many risks in doing so, it may not be worthwhile investing in it.

Another lesson to draw from Taleb's book is that if it was good fortune that brought you riches and success in the first place, be humble enough to acknowledge it. And take measures to safeguard your riches. Lady luck could turn one day. Then, lacking the perspicacity to understand how you got your wealth in the first place, you will not understand why you lost it suddenly. Don't be fooled by randomness.