The point we wish to make is not that simple strategies always perform on par or better than the complex ones. Our point is that complexity creates a problem for investors, which is unfortunately largely self-induced: complexity encourages performance chasing. We can better understand why this is true if we apply Daniel Kahneman’s construct of System 1 and System 2 thinking, as described in his book Thinking, Fast and Slow (2011). System 1 thinking is described as automatic, emotional, and passive, whereas System 2 thinking is effortful, deliberate, and active.
When presented with a complicated investment strategy, an investor engages first in System 1 thinking, which triggers an immediate response such as “I don’t understand the strategy. Clearly I’m not as smart as this asset manager.” System 2 thinking then takes over, and the investor’s response transitions to “Because this asset manager is so smart, her strategy must outperform. I think I’d like to invest with this asset manager.” The investor then feels safe and comfortable in making a rational delegation decision. At the end of the day, the acceptance of complexity is related to calming the investor’s ego—at least, temporarily.
This thinking works in reverse, however, if the asset manager fails to perform as expected. Neuroscientists, such as Knutson and Peterson (2004), have demonstrated that the anticipation of receiving money triggers a dopamine reward in the brain. Conversely, the anticipation of losing money removes that pleasurable experience. When this happens, the System 1 response is “Yikes! I need to fire this manager so I can stop feeling so bad.” Then the System 2 response kicks in with the rationalization, “I didn’t make the decisions that created the underperformance, so I’m not to blame.” Because the investor doesn’t “own” making the “bad” decisions, it is easier to end the relationship.
Following this line of thinking, investors are liable to sell a complicated, poorly understood strategy with little provocation as soon as performance takes a nose dive. The long-term result is apt to be especially disappointing performance if the investor becomes ensnared in a whipsaw pattern of buying and selling at all the wrong times. Our research (Hsu, Myers, and Whitby ) shows that the frequent hiring and firing of managers based on short-term performance is the primary cause of investor underperformance. Our findings are valid even when investors hire skilled managers. Although never a good idea for investors to make buy and sell decisions based on short-term performance, a poorly understood strategy can compound the harm.
An example of how Kahneman’s System 1 and 2 thinking supports an investor’s choice of a simple behavioral factor strategy, let’s consider the following scenario. Upon first encountering the strategy, the investor’s System 1 thinking blurts, “This strategy is intuitive to me. I am a smart investment professional. This will work.” But soon his System 2 thinking chimes in, “I don’t need to pay a high fee for this. I just need a low-cost implementer of systematic strategies to execute on my chosen factor.” When the strategy fails to perform as expected, the investor’s System 1 reaction is, “I am not wrong. The market is wrong.” Then his System 2 thinking kicks in, reasoning, “I vetted the research behind this factor carefully. Short-term performance is noisy. This exposure will work well in the long run.” The investor chooses to hold his strategy.
Investors in simple strategies generally trade in and out of their managers infrequently. Our research finds that these investors tend to achieve meaningfully better results versus their counterparts who actively turn over managers due to recent performance. Simplicity leads to better investor outcomes not because simplicity in and of itself produces better investment returns, but because a simple strategy forces investors to own their decisions and to be less likely to overreact to short-term noise.