Investing is complex – know your threshold

This week, I introduce another new term to your investment lexicon. The term is “complexity threshold,” and you need to know yours.

It is a complicated matter to manage money, whether it is yours or someone else’s. I think of it as a small glade of trees, like you might find in your backyard. Each tree represents a major asset class. One tree is stocks; another is bonds. There are a few more trees for things like cash, real estate or commodities, and so on. But, there really aren’t all that many trees. Let’s say there are 10 trees in the yard.

We can manage the task of getting to know a little something about each of these trees. After all, there are only 10 of them, and we could spend a fair amount of time getting to know each one quite well. Investing decisions start with the basic choice of deciding how much money to put in each asset class. We can attribute upwards of 90 percent of the quarterly variation in your investment returns to the simple choice between three assets: stocks, bonds or cash.

Now, this isn’t to say that making such choices is easy. We can do it right, or we can do it wrong. But, at least we are dealing with only a handful of possible outcomes. If we can manage to know a fair bit about our set of 10 choices, we will do fine in the long run. Ten choices seems like a manageable number; in most investment environments, four or five will do the trick.

But now let’s take a look farther up the tree. Each tree trunk begins to branch out. The tree for stocks first splits into domestic and foreign branches. Then it splits into value stocks and growth stocks, both small and large. Then into various industries and sectors. Each of these branchings will double or triple the number of choices. What looked like a single choice - stocks - turns out to be dozens of choices, and we haven’t even started looking at individual companies yet! We might think of those as the leaves.

Over on the bond tree, we have short and long bonds, taxable and tax-exempt, domestic and foreign, and literally hundreds of variations on a theme.

The complexity of our investment decisions begins to explode. As a mere human being, I cannot become an expert in thousands of various investment instruments. I have a complexity threshold, and it sits at no more than 20 things. I can understand, on a fundamental and thorough level, about 20 things. And, if I may say so, I am a Mensa member and I don’t lack the basic horsepower to understand things. My threshold is surely lower than some others’, but nonetheless, we all have a threshold.

By being aware of our individual complexity thresholds, we can know where to draw the line in our decision-making. If you understand the overall potential for large cap stocks, you might stop there and give your investment dollars to somebody that specializes in large-cap stocks. The decision to own large-cap stocks is within your threshold; the decisions about which stocks to actually buy is beyond your threshold.

Since the person to whom you have assigned the large-cap stock branch on the tree has her own complexity threshold, she probably doesn’t know much about foreign bonds. She uses up her complexity limit just picking stocks for your mutual fund or brokerage account. So, you probably shouldn’t take advice about foreign bonds from somebody that studies large cap stocks all day.

I encourage you to think about your own limits of making complex decisions. You should also have this conversation with your broker or advisor. What is your, or their, core competency? What are the dozen or so things that you or they can understand very well, and what are the things that are best left to others?

In my practice, I work to understand the relative valuations of the major conventional asset classes, such as large- and small-cap stocks, real estate and a few flavors of bonds. I also form an opinion about foreign versions of these assets. I spend enough time on these few things that I cannot then pretend to be able to pick which stocks to buy. No one of us can know it all. The best investors know where to set their own boundaries, and then focus their energies on picking the best decision-makers. If you or your advisor steps over the complexity threshold, chances are you will make mistakes.