—Warren Buffett
The way Buffett deals with difficult problems is to avoid them altogether. Unlike the figure skaters at the Olympics, we don’t get extra points for higher degrees of difficulty in investing. Originality and complexity are not necessary or sufficient conditions for generating superior long-term returns. As investors, our job is simply to compound capital over time at the highest possible rate with the minimum amount of risk. We achieve this objective by seeking out undervalued stocks of companies within our circle of competence. Be completely indifferent to whether the market cap is large or small or to whether the company is relatively unknown or widely followed.
Investing is not about being original or creative; it is about looking for the greatest amount of value (for the price paid) with the least amount of risk. Putting in more time and effort does not guarantee better results in investing. Rather, it is more beneficial to do less and make fewer but better choices.
The more decisions you make, the less willpower you have. It’s called decision fatigue. Focus on making fewer and better decisions. This allows you sufficient time to think about each decision deeply and reduces the chances of making a mistake. We should restrict ourselves only to those cases in which the investment decision looks like a no-brainer. As Charlie Munger says, “The goal of investment is to find situations where it is safe not to diversify.”5
Look for simple businesses that require fewer assumptions and fewer hypothetical scenarios to work out and that do not require discounting cash flows from way out into the future to justify the investment. As Thomas Carlyle aptly put it, “Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand.” In his 2004 letter, Buffett highlighted the importance of sticking to simple propositions:
If only one variable is key to a decision, and the variable has a 90 percent chance of going your way, the chance for a successful outcome is obviously 90 percent. But if ten independent variables need to break favorably for a successful result, and each has a 90 percent probability of success, the likelihood of having a winner is only 35 percent…. Since a chain is no stronger than its weakest link, it makes sense to look for—if you’ll excuse an oxymoron—mono-linked chains.6
It is important to identify and focus on the few key variables that really matter to an investment decision. This vastly simplifies the process and improves the probability of a successful outcome. The Occam’s razor mental model is useful because it enables us to separate the long-term signal from the short-term noise and to calmly think through any investing decision. Yes, reading the annual reports, filings, press releases, and footnotes to the accounts is important, and occasionally, we will be able to dig out some extra detail that might give us an analytical advantage, but, in my view, understanding the big picture (the two to three key variables that really matter) is equally, if not more, important. Some of us may be average at business valuation but still can achieve above-average results by being able to better put the available information in the appropriate context, by remembering the big picture, and by being able to pinpoint the few factors that really matter to an investment.
In one of his lectures at Columbia University, Joel Greenblatt taught his students the importance of always keeping the big picture in mind: “Explain the big picture. Your predecessors failed over a long period of time. It has nothing to do about their ability to do a spreadsheet. It has more to do with the big picture. I focus on the big picture. Think of the logic, not just the formula.”7
In investing, simplicity is the way to long-term success. Buffett says: “The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective…. We haven’t succeeded because we have some great, complicated systems or magic formulas we apply or anything of the sort. What we have is just simplicity itself.”8
Simplicity is the art of thoughtful reduction. It is a systematic falsification of deeply held beliefs. Conan Doyle’s fictional character Sherlock Holmes once said, “If you eliminate the impossible, whatever remains, however improbable, must be the truth.” In contrast, complexity opens you up to far more possibilities and surprises, possibly in a harmful way.
Buffett has been emphasizing the idea of simplification for a long time. He wrote in his 1992 shareholder letter, “We try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change, we’re not smart enough to predict future cash flows. Incidentally, that shortcoming doesn’t bother us.”9
Munger agrees: “We have a passion for keeping things simple. If something is too hard, we move on to something else. What could be more simple than that?”10
Observe how Munger is able to greatly simplify the path to wealth creation: “Spend less than you make; always be saving something. Put it into a tax-deferred account. Over time, it will begin to amount to something. This is such a no-brainer.”11
Intelligent people are drawn to complex solutions. Plenty of smart and highly educated people work in the world of finance. But that intelligence often comes at a cost, because smart people can more easily fool themselves into believing they have all the answers. That can get them into big trouble. As Albert Einstein said, “If you can’t explain it simply, you don’t understand it well enough.”
According to William James, “The art of being wise is the art of knowing what to overlook.” This is true not just for business problems but for people as well. As Buffett cautions, “You can’t make a good deal with a bad person.”12 This is precisely the philosophy he has followed in his business and personal life. He has chosen to work only with people he admires and trusts. As a result, he has rarely had to deal with nasty problems created by bad people.
Although Occam’s razor is a useful mental model, it should not be seen as a substitute for empirical testing. It relies on subjective assessment of simplicity and looks for approximate or “good enough” solutions to the problems at hand (also known as “satisficing”). It is not a rule. It is more of a guide or a suggestion.
Sherlock Holmes would look for the simplest, most natural explanation for a case, but he also believed in not oversimplifying complex matters, especially when dealing with systems involving complicated interactions.
Similarly, Albert Einstein believed in the power of simplicity, but he also understood its limitations: “Everything should be made as simple as possible, but no simpler.”
For example, the reason for the popularity of the price-to-earnings (P/E) ratio is its simplicity and accessibility. A ratio of 20× simply means that a company is available at a market capitalization that is twenty times its annual earnings. In other words, the stock price is trading at twenty times its earnings per share. The P/E ratio in isolation, however, tells us nothing about the business’s capital intensity, cash flow generation, management quality, or balance sheet strength, or about the expected duration of its competitive advantage period. There’s a lot more to making money in the stock market than just looking at P/E ratios. (Every investor should diligently study the white papers titled “What Does a Price-Earnings Multiple Mean?” and “The P/E Ratio: A User’s Manual” by Michael Mauboussin and Epoch Investment Partners, respectively.13)
Three Steps to Simplification
Complexity is about tactics; simplicity is about systems. Tactics come and go but an overarching philosophy about the way the world works can help you make better decisions in multiple scenarios. Simple doesn’t go out of style but complex does.
—Ben Carlson
The first step in simplification is to avoid wasting time on things that are unknowable and unimportant. Before attacking a problem, ask whether it is important and worth solving. Buffett explains, “There are two questions you ask yourself as you look at the decision