Have you ever sat in a wobbly chair? What about sitting at a wobbly table at a restaurant? More than likely, that chair or table had four legs, not three.
Many people assume that a 4-legged chair or table would be more stable than a 3-legged version. However, due to the wonders of math, it turns out that a 3-legged chair is the epitome of stability.
You see, having only three points of contact, instead of four, guarantees that those three points will rest in the same geometric plane.
In this case, the relevant geometric plane would be the floor underneath the chair. It makes no difference how orient the points or even if one of the legs is not the same length as the other two. The base of all 3 legs will always remain firmly on the floor. No wobbling. At all.
However, if you add in a fourth leg, then you can run into trouble. If the legs are not cut precisely to the proper length, or if the floor is warped or slanted, then you often get a nasty wobble. This holds true for more than four legs as well. Let’s imagine a chair with infinite legs (it might be something like a “circle” of legs). Place it on an uneven floor, and it will also wobble.
In fact, there are some furniture designers who believe that all chairs and tables should use the 3-legged approach, instead of the more standard 4-legged. This is also the reason that photographers use a tripod.
What does this have to do with personal finance?
One aspect of personal finance that often gets overlooked is the notion of “addition by subtraction.” In the case of the 3-legged chair, we are “adding” stability by “subtracting” a leg. We end up with a better result by removing an element, not by adding one.
In many cases, humans have a bias towards addition when it comes to solving problems. We like bigger and better. Bigger cars with more fancy features. Bigger houses with the latest furnishings and materials. The latest technology with the newest applications and abilities.
Investment funds
We often follow this trend with our investments as well. Many investors (including financial advisors) are guilty of creating overly complex investment portfolios. They might have 10, 20, 30, or more investment funds (or single name stocks, GASP!). If you drill down though, many of these investments can have a significant overlap in the underlying holdings, which can reduce diversification and the effectiveness of the investment strategy.
In the vast majority of cases, investors can get great results through subtraction. Most people can do just fine with anywhere from 1-5 funds. If you want to add more sophisticated strategies (e.g. factor investing), they you may need between 5-10 funds. But in many cases, keeping your investment portfolio as simple and streamlined as possible will offer great benefits.
Advisor fees
Financial advisor fee schedules can also be improved through subtraction. Flat fee advisors such as myself, have “subtracted” out all the complexity and additional cost of the typical 1%-of-assets fee model. And our clients can benefit as a result.
Contrary to what many financial advisors believe, it can be difficult for many clients to conceptualize the true cost of asset-based fees. For example, here is a fee schedule for an advisor that I came across recently:
- 1.00% up to $2.5mm
- 0.85% between $2.5mm and $4mm
- 0.75% between $4mm and $5.5mm
- 0.70% between $5.5mm and $7mm
- 0.65% between $7mm and $8.5mm
- 0.60% above $8.5mm and $10mm
- 0.55% above $10mm
Let’s ignore the fact that there are seven “breakpoints” in this fee schedule (seems overly complex to me, but whatever). If you have a portfolio with $5,200,000, then how much is your fee? Unless your good at combining multiplication with weighted-averages, the easiest way is to use an “add it up” approach:
(1% x $2.5mm) + (0.85% x $1.5mm) + (0.75% x $1.2mm) = fee amount
$25,000 + $12,750 + $9,000 = $46,750
In almost every case, the client will need a calculator to figure their fee. And I’m not trying to insult the intelligence of people. Of course they can work through the math if they want to, but why should they have to?
And the fee changes from quarter to quarter! Do the services offered by the advisor change every quarter? Not likely! So why does the fee?
Another way to look at this… why do financial advisory fees need to be so complex?
When I was in the U.S. Army we used to repeat an acronym over and over… KISS. It stands for “Keep it simple, Stupid.” This was a good way to remind ourselves that good solutions can arise out of simple processes or action plans.
Here’s a good example I read about a while back:
A team at the U.S. State Department needed to deliver a diplomatic package to a very dangerous country with very limited access. The State Department put in a request with the U.S. Army’s elite Delta Force unit to get the job done. As part of the planning process, the State Department personnel recommended that the Delta Force team members conduct a high altitude, low opening (HALO) parachute jump into the ocean of the coast of said country, and then swim to land and perform an over-the-beach infiltration before changing clothes and sneaking the rest of the way to the drop point. Needless to say, this plan is very high risk.
The Delta Force guys simply chuckled. Instead they opted for KISS. They took a civilian airline flight to a neighboring country. They rented a car at the airport and drove to the border with the target country, where they met a contact who lived in the target country. They handed the contact the package, drove back to the airport, and flew home. The contact drove the package the rest of the way to the delivery point. Mission accomplished.
Where the State Department was hoping that Delta Force would deliver a “high speed” solution, the Delta Force guys merely wanted to get the job done and come home safely.
Just remember that complexity does not always equal success. Often, success can be achieved through a simple, but well executed plan.
