The complexity trap and how to avoid it

If a business is too complex for you to understand, then the problem is probably not with you: it’s with the business.

Deep in the recesses of your investing memory, you may recall the ‘financial engineering’ stocks of the pre-GFC era, Macquarie Group (ASX:MQG) copycats that, unlike Macquarie, crashed and burned when the GFC hit.

Even with the passage of time, the damage they did to investors’ hip pockets is astonishing to contemplate. Babcock & Brown hit a high of $34.78 in 2007 but went into liquidation in 2009. Allco Financial Group followed a similar path, trading as high as $13.24 in 2007 but collapsed in 2008. There were others, many of which are detailed in Adam Schwab’s book, Pigs at the Trough.

Occam's razor

Was there any way to avoid these disasters? A 14th century English Franciscan friar, philosopher and theologian would say ‘yes’. William of Ockham believed that, “When faced with two possible explanations, the simpler of the two is the one most likely to be true”.  The theory, known as Occam’s razor, states that “Entities must not be multiplied beyond necessity”. This was the rule that Allco and Babcock & Brown broke.

Albert Einstein, a great believer in making ideas easy to understand, explained the principle thus: “Everything should be made as simple as possible, but not simpler”. Keeping things simple when investing is a good rule of thumb. As Charlie Munger has said, “Simplicity has a way of improving performance through enabling us to better understand what we are doing”. When analysing potential investment opportunities, Berkshire Hathaway (NYSE:BRK.A) places each into one of three baskets: a ‘Yes’, ‘No’ or ‘Too hard’. Anything that’s too hard to understand goes into the ‘Too hard’ basket and everyone moves on.

Why? Because too much complexity within a business can hide unacceptable levels of risk that can bring a company undone. Allco had a complex structure of 66 subsidiaries that facilitated a web of related-party transactions and multiple conflicts of interest. Described as a “spaghetti mess” it collapsed in 2008 with $1.1bn of debt.

The larger crisis that exposed Allco’s complexity has its own issues. Investment bank CEOs struggled to explain some of the products they sold and how they worked (badly or not at all, as it turned out), let alone the risks to customers, investors and the global banking system. When the dominos began to fall, most were caught unawares.

Hiding mistakes - and risk

Complexity has a way of hiding mistakes and covering risk. The more complex a system, product or algorithm, the more likely it is to contain errors and oversights. This need not be deliberate, merely a function of how systems gradually change over time, to the point where simplicity is lost and holes created. Australia’s tax system and superannuation systems are good examples.

One of the beauties of simplicity is its clarifying force, one that makes understanding easier. As Leonardo Da Vinci said, “Simplicity is the ultimate sophistication”. It’s also Occam’s tool to steer you clear of investments that might look attractive but have hidden risks. If a business is too complex for you to understand, then the problem is probably not with you: it’s with the business. If you can’t understand a company’s structure and how it makes money, follow Occam’s Razor and don’t invest in it.

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