There seems to be some perverse human characteristic that likes to make easy things difficult. – Warren Buffett
The great paradox of this remarkable age is that the more complex the world around us becomes, the more simplicity we must seek in order to realize our financial goals. Never underrate…the majesty of simplicity….Simplicity, indeed, is the master key to financial success. – John C. Bogle
I have loved “The Barometer Story,” by Alexander Calandra, since a teacher shared it with a class I was in many years ago. The story is about a dispute between a physics professor and a student over the student’s response to an exam question.
The question was, “Show how it is possible to determine the height of a tall building with the aid of a barometer.”
The student’s answer was, “Take the barometer to the top of the building, attach a long rope to it, lower the barometer to the street, and then bring it up, measuring the length of the rope. The length of the rope is the height of the building.”
The professor had given the student zero credit for the answer, but the student maintained that he had answered the question correctly, and deserved full credit. Calandra was called in to mediate the dispute.
Calandra admitted that the student had answered the question correctly. However, his answer had not demonstrated an understanding of physics, which was the purpose of the exam. Therefore, as a compromise the student was allowed to answer the question again, and given 6 minutes to do so.
After 5 minutes the student had not written anything, so Calandra asked him if he wished to give up. He replied that he had thought of many ways to answer to the question; he was just trying to think of the best one. With time running out he quickly wrote:
“Take the barometer to the top of the building and lean over the edge of the roof. Drop the barometer, timing its fall with a stopwatch. Then, using the formula S=½ at˄2, calculate the height of the building.”
This was not the answer the professor was looking for, but he had to admit it was not only correct, but appropriately applied a physics principle. The professor gave up and awarded the student credit on the question.
As they were leaving Calandra remembered that the student had said he had thought of many answers to the question, so he asked him what some of the others were. The student recounts several, but my favorite is, “[take] the barometer to the basement and [knock] on the superintendent’s door. When the superintendent answers, you speak to him as follows: ‘Dear Mr. Superintendent, here I have a very fine barometer. If you tell me the height of the building, I will give you this barometer.”
The point of the story is that for most problems there are many different solutions, and we shouldn’t limit ourselves to the conventional one. This is definitely true in personal finance. Almost any personal finance problem you can think of, from budgeting, to insurance, to investing, has multiple possible solutions. So how do you know which solution to choose?
A math professor of mine once shared another great story. This one happened to him personally. He was on a long flight as part of a family vacation, when, not long after takeoff, the pilot got on the intercom and announced that there would be a contest, with a prize for the winner.
The pilot announced the speed and direction they were flying, how many miles they were from their destination, and the speed and direction of the wind. He then invited those who wanted to participate in the contest to write down an estimate of what time they would land.
Many of the passengers were in no mood for a rather complicated story problem during their vacation, but the math professor thought it sounded like great fun, so he quickly pulled out a piece of paper which was soon filled with complicated calculations.
A few minutes later he handed his answer to the flight attendant who was collecting the responses. He proudly noted that his teenage daughter had also taken the time to come up with an answer.
Shortly after landing the pilot came on the intercom and announced the winner. The professor’s answer had been close, but he hadn’t won. Instead, the pilot announced that his daughter had won the contest. The math professor was now positively beaming with pride.
Wondering how his daughter had calculated an answer even more accurate than his own he asked her how she had done it. She pulled out her ticket, but instead of showing him her calculations she simply pointed at the printed arrival time and confessed that she had used that.
When presented with a problem the math professor automatically used the tools he had spent his life working with, not even stopping to think if there might be a simpler solution. His daughter took a different approach. Knowing that the flight had left on time, she figured the airline had already done the math at a higher level than she was capable of, so she relied on their calculations.
The professor had made an easy problem difficult, while his daughter had used the simplest possible method that would get her close to the right answer. In this instance, as is often the case, simplicity won.
The principle of using the simplest method that will solve a problem is known as Occam’s Razor, named after the fourteenth-century philosopher and friar William of Occam, who is credited with formulating it. One version of Occam’s Razor states, “When confronted with multiple solutions to a problem, choose the simplest one.”
Beware Complexity in Personal Finance
Richard Thaler, a pioneer in behavioral finance, stated that one of the key lessons he had learned in a lifetime of studying human behavior is, “If you want to encourage someone to do something, make it easy.” Unfortunately this principle comes with a sinister corollary, which is, “If you want someone to pay you lots of money to help them do something, make it complicated.”
Wall Street has enriched itself by ignoring Thaler’s Rule and perfecting the use of the corollary. Speaking of this David F. Swensen stated, “As a general rule of thumb, the more complexity that exists in a Wall Street creation, the faster and farther investors should run.” Larry Swedroe added, “…you would do well to realize that whenever Wall Street has invented a better mousetrap, you can be sure that you’re the mouse.”
Complexity is the enemy of action and the friend of procrastination. Since change is impossible without action your goal is to use Occam’s Razor to choose the simplest solutions that will help you reach your financial goals, and then take action. Here are some simple actions you can take right now:
Budgeting: The purpose of a budget is to make sure you spend less than you make, save for the future, and spend money on the things that are important to you. You should choose the simplest tool that will accomplish this. If your finances are not too complicated, the simple budget suggested by Andrew Tobias in his excellent book, The Only Investment Guide You’ll Ever Need, just might do the trick:
“Destroy all your credit cards. Deposit the first 20% of each paycheck in one or more investment accounts that you never, ever touch….Put the remaining 80% in a single checking account and make do, no matter what, with the balance in that account.”
This won’t work for everyone, but for many people this could be all you need. Only add complexity to the system above if it is necessary to help you accomplish your goals.
Life Insurance: Like the professors in our story, life insurance agents will try to sell you complicated (and expensive) solutions to a simple problem because that is what they know. Their solutions will likely combine insurance and investments in a package that doesn’t perform either function particularly well while overcharging you for the privilege.
Jim Stovall said it best when he wrote, “Life insurance is one of the simplest parts of the financial plan that is made the most complex. Don’t let it be. Invest with investments and insure with insurance.”
The tool to simplify life insurance is to buy a simple term life insurance policy. But how do you know what type of policy to buy and how much insurance you need. Carl Richards provides an incredibly simple answer that will work for most people. He calls it “the 20-20 plan.” It consists of the following two steps.
- Step 1: Take your salary and multiply it by 20
- Step 2: Buy a 20-year term policy for that amount
Read more about Richard’s 20-20 plan here: Life Insurance Made Easy
Investing: In only a slight exaggeration, Nobel Prize-winning economist Paul Samuelson called the invention of the first index mutual fund by Vanguard Founder John Bogle the equivalent of the invention of the wheel and the alphabet. He then added that with index funds available, “The prudent way [to invest] is also the easy way.”
Index funds allow the small individual investor, with very little knowledge and even less time commitment, to beat the vast majority of professional fund managers. Index funds are the ultimate simple solution and seem almost too good to be true.
Even more amazing, you can invest in the stocks of thousands of different companies, both here and internationally, by investing in only two index funds:
- A Total US Stock Market Fund
- A Total International Stock Market Fund
Add a Total Bond Market Index Fund, and with only three simple investments you will have a portfolio that is diversified by both asset class and geographically. It really can be that simple. And if you shop around you can do all this with fees that are incredibly low.
This would have been impossible less than fifty years ago. We are truly living in the golden age of investing for the small individual investor and for that we all owe a debt of gratitude to John Bogle.
There will always be professors, insurance salesmen, financial planners, and hedge fund managers trying to convince you that the complicated solution to your problem is the only viable one. They are rarely right. So whether you are using a barometer to measure the height of a building, estimating what time your plane will land, or managing your money, ignore them.
The “right” method for you is the simplest option that meets your needs and helps you accomplish your goals. Never forget the majesty of simplicity.
Additional Reading: Simplicity is the Ultimate Sophistication