Keep investing as simple as possible

What do fine wines and investing have in common?

a woman

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Predicting the quality of a fine wine has long relied on the sniff-swish-and-spit taste method. Critics use palettes and noses honed over years to assess a wine's future value. Results, unsurprisingly, can be mixed. Two vintages once deemed equal quality can end up varying in price by tenfold or more.

Princeton economist Orley Ashenfelter looked at this and shook his head. "I had never known if [fine wine] was all a bunch of B.S., [so my wife and I] tried some older Bordeaux wines, and they were fantastic," he once told BusinessWeek. Still, the price differences were astounding. "I would say: Now wait a minute, 1961 Chateau Lafite costs, say, $5,000 a case, and '62 costs $2,000 a case, and '63 costs $500. So what's the difference? What's going on here?"

"It was mainly the weather," he said.

Checking the numbers

We've always known that weather affects the quality of a vintage, but Ashenfelter doubled down and showed that just four variables — the age of the vintage, the average temperature during growing season, the amount of rain at harvest, and the amount of rain in the months before harvest — accurately explains 80% of the variation of a wine's future price. No swishing or spitting required.

In his paper, "Predicting the Quality and Prices of Bordeaux Wines," Ashenfelter notes that renowned wine taster Robert Parker ranked the 2000 vintage Bordeaux as one of the greatest ever produced. "And yet we learned this without tasting a single drop of wine."

Ashenfelter outsmarted wine snobs with a simple formula that stripped the problem down to the few variables that mattered most. No emotion, no opinion. Just the facts, thank you very much.

Investors may be wise to do the same.

There are no points awarded for difficulty in investing. The investor with the most complicated model or the most elaborate theory doesn't always win. Indeed, elaborate theories can often be the fastest route to self-delusion.

Keeping it simple

In 1981, Pensions & Investment Age magazine published a list of money managers with the best track records over the previous decade. One year, a fellow named Edgerton Welch of Citizens Bank and Trust Company topped the list. Few had ever heard of Welch. So Forbes paid him a visit and asked him his secret. Welch pulled out a copy of a Value Line newsletter and told the reporter he bought all the stocks ranked "1" (the cheapest) that Merrill Lynch or E.F. Hutton also recommended.

Welch explained: "It's like owning a computer. When you get the printout, use the figures to make a decision — not your own impulse."

I'm not suggesting a similar approach. I couldn't find what ever happened to Welch's track record. But as Forbes summed it up, "[Welch's] secret isn't the system but his own consistency."

Simplicity and consistency. That's the key. It's taking emotion out of the equation and focusing on the few variables that count. Ashenfelter, Beane, and Welch all believed in this idea. Study enough successful investors, and I think you'll find it as a common denominator.

Rules to invest by?

Some have proposed simple investing rules that have a good record of success. In his book The Little Book That Beats the Market, hedge fund manager Joel Greenblatt proposes ranking a broad group of stocks by two variables: earnings yield (cheap companies) and return on capital (good companies). Buy a basket — say, 30 — of the highest-ranked stocks. Rinse, repeat. Greenblatt shows this simple formulaic approach has easily beaten the market over a multi-decade period.

Wharton professor Jeremy Siegel ranked S&P 500 companies by dividend yield and showed something similar. In short, the quintile with the highest yields delivers an average annual return almost five percentage points higher than the quintile with the lowest yields.

Other studies show a basic rebalancing of assets — buy stocks when they're down, sell bonds when they're up, and vice versa — every year can lead to superior returns if done consistently over time.

Foolish takeaway

Past performance is no guarantee of future return. These strategies may be entirely spurious. The more data you search through, the higher the odds you'll find what you're looking for, whether it's real or cherry-picked. And as Einstein put it, "Not everything that can be counted counts, and not everything that counts can be counted." Brand loyalty, corporate culture, and trustworthy management are all things that can't be captured in a formula, but that we know are characteristics of great investments.

But many of us are emotional investors. We often make completely different decisions based on tiny changes in mood or circumstance. Simple, consistent, and formulaic investment approaches don't suffer from that bias. Any chance to substitute emotion with unbiased facts is likely a step in the right direction.

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A version of this article, written by Morgan Housel, originally appeared on fool.com.

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