Complexity is Not a Financial Plan
Have you ever been in a situation where someone is talking your ear off about some investment that they seem very excited about but doesn’t quite make sense to you? Maybe it’s a cryptocurrency, or maybe it’s a rental unit with some attractive tax breaks? Does it make you feel stupid and perhaps a little bit bored and annoyed at the person? You’re not alone. This isn’t a new phenomenon. There have always been those people hyping up a scheme or strategy that they have had recent success with, which inadvertently makes you feel like you missed the boat. It feels good for the winner and they feel like they have to share the good news that they have one-upped you, they have gamed the system, and they are smarter than the masses just doing the boring thing. It’s the basic concept of risk and reward. Take more risks, and have the potential for more reward. Take less risk, and have less potential for reward but also less potential for ruin. I’d like to define risk as complexity.
From my perspective, complexity is creating short-term stress to manufacture the feeling of having an edge above everyone else. In my work as a financial planner, I have clients always looking to take more risk and to introduce more complexity to their financial lives, but at what cost?
Sometimes our financial planners can sound like broken records by delivering the same sound and simple advice when it comes to investing. The advice is straightforward: invest regularly into a diversified portfolio that’s adjusted over time according to your wants and goals while taking opportunities for tax arbitrage as the market moves. That’s certainly not as sexy or exciting as “I made $10,000 yesterday from my living room trading stocks.” But engaging in highly risky and short-term return-chasing investments truly comes down to being in the right place at the right time and having the emotional chutzpah to get out when you’ve made enough money. And the flip side is that with the amount of risk that must be taken to chase short-term reward, the most likely outcome is loss.
So what does unnecessary complexity look like in a financial plan?
It could mean creating a portfolio of rental properties that must be individually managed.
Engaging in day trading of individual securities and trying to beat the market.
Heavily investing in alternatives like cryptocurrency or gold.
Here are some examples of what I view as complexity for complexity’s sake.
Said another way: why the heck would you take so much concentrated risk when you don’t have to?
Borrowing against your stock options. Leverage is too risky for most individuals. A large investment bank that shall remain nameless has a habit of pitching unsuspecting tech employees on borrowing against their stock options at newly public companies. If your equity makes up more than 20% of your net worth you cannot afford to take this risk and further concentrate your net worth into one stock!! Just sell the damn stock! You know who wins big on these pledged asset lines of credit? The investment banks collecting the fees from you to do the transaction in the first place. Even if your stock goes to 0 and you lose everything, the bank is still entitled to their fee.
Rental real estate. In my experience, the people making real money in rental real estate are large investment banks that can mitigate the risk across thousands of homes and the content marketers who have YouTube channels called Rental Real Estate to Riches (I made that up, but you get the gist). Rental estate CAN be a great way to earn passive income but the stars have to align through so many periods of economic change (rising interest rates, home prices, etc.) in order for it to be a net positive investment. You may hear so many rental real estate success stories, but you don’t hear the failures that utterly destroy a person’s financial plan. We don’t hear the stories of destructive tenants who won’t leave, local rental laws that change, supply and demand, and so many more things that make investing in properties so damn complex.
I’m not saying there’s NO place for these riskier investments in your portfolio, I’m saying they should not make up the majority of it. It’s my view, and a very popular opinion among investment advisors that it’s okay to take some risk in your portfolio - depending on your tolerance for loss, it’s usually 5-15% of your overall net worth. So, for example, if it has always been the deepest desire of our heart to run an Airbnb cottage and your portfolio is currently about $6 million, it would be totally reasonable to invest in a $700,000 rental property. There’s enough diversified portfolio left over to sustain you if that investment goes belly up.
Why Simplicity Works
The global stock markets have provided us with an incredible opportunity to participate in other people’s success without leaving the comfort of our living rooms. But as humans, we have a tendency to want to do something, to cause change, to be better than the next guy. But why? Why introduce that complexity when 100 years of stock market history has shown us it’s not necessary to take that much risk to slowly build up your net worth over time?
When you take away all the tax planning, insurance planning and risk management, investment strategy, home purchase analysis, and other stuff, at its most basic form, a financial plan consists of defining your ideal life, projecting how much it will cost to live that life, and making sure there's enough money to pay for it.
Rules of Thumb for Avoiding Unnecessary Complexity in Your Financial Plan
1. It's okay to have complex investments but they shouldn't make up the majority of your net worth
2. Complexity leads to stress, whether you know it or not. We don’t talk about this one enough. Investing in volatile assets for the short term can cause unnecessary stress and anxiety that’s literally harmful to your body.
3. There can be a place for complexity in your investment portfolio, but it's often more expensive than just doing the obvious simple thing. The big winners with added complexity are the people selling you the complex investment in the first place. That’s why you should ALWAYS work with a fiduciary to evaluate any investment option (note that most investment advisors at banks like Morgan Stanley, Merrill Lynch, and Fidelity are NOT fiduciaries).