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Ruthless Reductionism and Occam’s Razor

In the classroom we were constantly praised and awarded for complexity. A desire for higher marks meant creating more pages of writing, more conclusions, more assumptions, more models, more complexity, more and more. Yet when we exit the sterile classroom and apply that approach to the real world in search of profits, it often translates into less success, not more. Complex approaches usually fizzle out, whereas simple ones, combined with basic common sense and perseverance, tend to bring home the bacon.

The market teaches this lesson the hard way. It will take the complex, highly involved PhD thesis and spit it right back into your face in the form of a giant loss or even worse, a completely blown out trading account. The market doesn’t care about fancy complexity and therefore tends to reward the practical street hustler over the high level academic.

Long Term Capital Management’s blow out in the late 90s is a classic example of academia gone wrong. While the professors were scratching their heads as to why their ultra complex model failed, an unknown swimming pool contractor turned his original $10,775 into $18 million between June 1998 and December 1999.

It actually makes sense when you look at this phenomenon a little more closely. Nassim Taleb spells it out nicely.

“For, alas, though those who risk their own funds put a premium on simplicity and practicality, others—academics driven by “rank” and status, management consultants, economic “experts”, and finance analysts—have an incentive to indulge in complexity and muddle.” – NNT

Take Taleb’s observation and consider it in conjunction with this quote from one of our favorite market wizards:

“Win or lose, everybody gets what they want out of the market.” -Ed Seykota

While the academic, analyst, consultant, or keyboard warrior is looking for intellectual acceptance among a community or peer group, the street hustler practitioner is mining for one thing and one thing only -a profitable investing process. The pool contractor could care less whether or not his investment thesis is analysed and praised on CNBC. He wants profits plain and simple. He is in the game to make money and that’s it.

So how can we make sure we are acting like a street hustler instead of an intellectual?

There are two mental models we can use to assist us with staying on the right track.

  1. Ruthless Reductionism

We need to ruthlessly reduce any complexity that shows up in an investing process. Complexity always creeps into market analysis because there is so much free information available these days. We can’t help but be inundated by chart lines, indicators, real time news feeds, twitter feeds, talking heads, newsletters, etc. Information flow itself is not much of a edge anymore, but organizing information flow is. We want to ruthlessly reduce this flow into actionable ideas instead of creating elaborate theories on why an asset should move up or down. Leave the fancy theories for the cocktail parties when you are away from the quotes and your money is not at stake.

A profitable process is something that is actionable, understandable, and easily measurable. If you do not know exactly how a particular area of your process contributes to the bottom line, toss it out. It may sound fancy or make you look smart, but that is not the goal here. As a practitioner, the goal is singular, and that is to produce outstanding risk-adjusted returns. Reduce, reduce, reduce!

Reduction does more than just filter signal from noise, it is also tremendously helpful when it comes to evaluating trading results.

A process filled with too many variables, contingencies, and undefined areas results in an inability to accurately measure results. This leads to trading and investing disaster. Why didn’t the trade work out? If the reasons you entered the trade are convoluted or inconsistent with a total process, well then good luck finding out what actually went wrong. Was it an incorrect interpretation of the charts? Bad trade management? Psychological issues? Correlation issues? Wrong macro thesis? Maybe it was actually a sound trade but you just got unlucky. There is no way of knowing.  With too many moving parts it is very hard to identify the “bad apple.”

In order to improve and maintain an investment edge we must cultivate the ability to evaluate what is working and what is not. Times change, markets move, and this forces the prudent money manager to constantly reevaluate his investment process. The best portfolio managers relentlessly update and upgrade their process, but you need to have a solid handle on what your process entails before attempting to do either. The more you reduce complexity the easier this becomes.

  1. Occam’s Razor

Occam’s Razor, a principle conceived in the middle ages by a philosopher named William of Ockham, basically states that when given two opposing hypotheses, theories, or explanations the simpler one always prevails.

But why? Why is the simpler one better? Let’s break down the logic.

Hypotheses, theories, and explanations are nothing more than one’s interpretation and perception of the world around him. They are not fact. They are not the holy grail and they certainly are not the keys to the kingdom. A theory is only as good as its ability to be tested. Remember, in a hustler’s mindset, we don’t care if the explanation is “right” or not, we just want to know if it will pay us, ‘nuff said.

Simpler explanations are preferable to more complex ones because they are more testable.

A complex theory is usually one that started from a place of simplicity, but then failed in some capacity. Instead of tossing the explanation, more ad hoc hypotheses are added to prevent falsification.

To recap, we like simpler because it is easier to test and evaluate. The quicker and easier we can test and evaluate, the faster we can determine what is putting cash in our bank account and what is best saved for winning over the table at the next dinner party.

What does implementing Ruthless Reductionism and Occam’s Razor look like in practice? Let’s take a look at what to do as well as what not to do.

The academic’s approach to the markets looks something like this:

We want our process to look like this:

Theory and practice make up the two building blocks of process building. The academic spends more time constructing theory rather than practicing, the street hustling practitioner spends his time the opposite way, practicing over creating theory.The academic takes pride in his “insights” , assumptions and theories, while the practitioner is results oriented. Be like the practitioner, not the academic.

Keep Ruthless Reductionism and Occam’s Razor in mind while applying process to markets and remember: