Occam’s Razor: Cutting Through Complexity in Finance

We overcomplicate things. Even simple concepts are twisted and tangled into complicated webs of ideas. This is not simply a matter of personal observation; it is a cognitive bias known as complexity bias. When faced with two competing explanations for something, we lean towards the more complicated one, assuming that our inability to grasp it entirely is our fault rather than a flaw in the explanation itself.

Complexity bias helps explain why simple solutions are often overlooked while we fervently search for complex explanations. This bias sheds light on the wide-ranging nature of health, nutrition, and financial advice but also highlights the tendency to overcomplicate these matters. 

This is nothing new. Confucius said, "Life is really simple, but we insist on making it complicated." And while our knack for overcomplicating things is part of the human operating system, there are tools we can use to combat our inherent tendencies. My favorite is Occam's Razor.

Occam's Razor, also known as the principle of parsimony, is a philosophical and scientific principle attributed to the 14th-century English philosopher and Franciscan friar William of Ockham (or Occam). The term "razor" refers metaphorically to cutting away unnecessary assumptions and guiding one's thinking toward simplicity. Occam's principle suggests that when faced with competing explanations or hypotheses, the simplest one is the most likely to be correct.

The principle is based on the idea that adding unnecessary assumptions or complexities increases the risk of errors and complications without delivering additional explanatory power.

In such a noisy arena as investing, a sharp razor is necessary.

It's worth mentioning that while Occam's Razor is a useful mental model, it's not foolproof and may not necessarily lead to the right conclusion. Ultimately, the accuracy of a hypothesis hinges on the evidence and context surrounding it.s on the evidence and context surrounding it.

Here are some ways investors can apply Occam's Razor to enhance their decision-making processes: 

Investment Theses

Embrace Occam's Razor and seek simple explanations for a company's success or potential. By focusing on explanations that require fewer assumptions or complex narratives, you can zero in on the core factors that truly drive a company's performance and evaluate its investment potential more effectively.

Due Diligence

Cut through unnecessary complexities with Occam's Razor during your due diligence process. Keep your focus on the critical aspects that determine a company's value. Ask fundamental questions, assess the core business model, and scrutinize key metrics without losing yourself in a labyrinth of details.

Risk Assessment

By simplifying the risk analysis and focusing on the essential risk factors, investors can identify and understand potential risks more clearly. This can help in making informed decisions and implementing risk mitigation strategies.

Strategy

Occam's Razor can guide investors in developing investment strategies based on simplicity and clarity. Instead of relying on complex and convoluted strategies, investors can seek more straightforward approaches that align with their investment goals and risk tolerance. 

Decision-Making

Occam's Razor encourages investors to weigh the simplicity and plausibility of competing options. It promotes a focus on the most reasonable and straightforward choice, which can help when considering multiple investment opportunities or strategies.

When things get noisy and overly complicated, remember your newest tool, Occam's Razor. With a few mental cuts, you can trim the unnecessary complexity and get back to basics.