From Efficient to Effective – The Nature of Investing: Resilient Investment Strategies through Biomimicry

Transformation 1

From Efficient to Effective

Several years ago, I sat down with my parents to review their investments as they planned for retirement. There was nothing too crazy to discuss—they held no hidden Cayman Island accounts, no illiquid private equity funds, no time-shares in the Everglades. But there was a lot of complication for what was a simple savings plan: no fewer than eight different forms of government-backed savings vehicles, plus a long list of mutual funds that all mainly invested in large U.S. companies. Over the years, each time there was a chance to save a little more, my parents were guided to a new opportunity, and each opportunity was perfectly reasonable. But after forty years of new opportunities, rather than diversification, my folks had a lot of needless duplication. Just as importantly, they had account statements from all sorts of institutions coming out of their ears, which meant a lot of time and energy were required just to keep all of their records straight.

I see the same tendencies in my own consumption patterns, a sort of unintentional and unnecessary stockpiling. My cupboard often contains multiple cans of tomatoes, just because I can’t recall what’s there. My closet contains no fewer than ten black T-shirts, just because the newest one seems a little better or different. My portfolio summary lists dozens of stocks, just because each seems unique and intriguing. If these choices add something valuable—whether it’s better fashion choices or the enjoyment of learning about new companies—that’s fine. But in many cases, like my parents’, more does not mean better. When it comes to investing, what we need is not more complication, or false variety. We need deeper efficiency—true effectiveness.

Nature’s Principle: Be Resource and Energy Efficient

If there’s one thing Wall Street is supposed to have right, it’s efficiency. As recently as the early 1990s, just having the fastest fax machines or the bandwidth to receive real-time stock quotes could be a big advantage to an investor. Now, just twenty years later, those forms of efficiency seem quaint: large firms spend billions of dollars for ultra-fast trading systems, there are text crawlers that can automatically flag phrases like “lower guidance” or “higher revenues” in press releases, and I have seven different apps that provide me with real-time stock quotes right here on my phone. But efficiency is not just about speed, and it’s not just about cost. “Fast and cheap” is a common but shallow form of efficiency, one that feels good in the short term, but ultimately has hidden costs.

The natural principle, be resource efficient, reflects a much more nuanced, much deeper form. In nature, efficiency includes sophisticated design principles, like multifunctionality, and fitting form to function. Natural efficiency is not the same as a quick fix; it is true effectiveness. The subprinciples of resource efficiency are:

  • Use multifunctional design.
  • Use low-energy processes.
  • Recycle all materials.
  • Fit form to functions.

For example, have you ever seen a duck preening itself beside a pond? I have to admit, it never seemed a remarkable sight to me, until I learned about the amazing design elements of the duck’s preen oil. This oil is amazing stuff, and a great illustration of the subprinciple of multifunctional design: it is produced by the duck’s own body, can be used for both feather waterproofing and duck-bill moisturizing, and it breaks down into vitamin D when exposed to sunlight. This oil is not just an efficient product by shallow standards (fast and cheap); it is effective, performing many functions with simple, internally sourced materials.1

A perfect illustration of the second efficiency subprinciple, use low-energy processes, is the toco toucan. The toucan’s bill serves many purposes, and one of the most interesting is as a heat exchanger. When it’s colder, the toucan reduces blood flow to its bill, keeping more of that heat inside. And when it’s warmer, blood flow increases, allowing more heat to escape through the large surface area of the bill. The toucan does not need to flap its wings to get warm or seek out an external, high-energy cooling mechanism: this adjustment all happens internally, and efficiently.2

The third subprinciple in this section, recycle all materials, is well demonstrated by the hermit crab, source of many childhood nightmares for me (click … clack … click). If I’d known about the principles of resource efficiency, at least I could have put that sleepless time to good use, thinking about how effective the hermit crab is in finding its home. Hermit crabs are the squatters of the seaside scene: they find an empty shell and move right in. But they don’t take just any shell: their behavior is influenced by both what’s available and by the condition of their current dwelling. Shells are recycled constantly, in a way that maximizes benefit.3 Maybe they are not as flashy as the big-billed toucan, but the crabs illuminate resource-efficiency principles just as the birds do.

The final subprinciple related to efficiency, fit form to functions, is elegantly embodied in all sorts of organisms, such as the cactus species lophophora. This type of cactus is designed to shrink when water is scarce, so much so that its shoots flatten out and retract all the way underground. Then when water is available, the shoots pop back up again aboveground. The form is perfectly designed to fit the essential function of water management.4

As we translate the principles of resource efficiency from biological settings to a human setting, it’s important to note three fundamental concepts that are embedded within the directive to “be resource efficient.” First, form and function go hand in hand, and are based on need. Performing unnecessary functions is, by definition, not efficient, since there is no meaningful benefit produced. And providing function with a mismatched form is wasteful, using more energy and resources than are truly required. Say you have two forms of transportation—your feet and a sailboat. And you have two destinations—the corner store and a remote island. Well, none of these components is inherently “good” or “bad”—but the combination of your feet and the trip to the corner store obviously matches form and function, whereas it would waste a lot of energy to try to walk (or swim) to that island. Behind every function is a need, and for every function there is a form. If it’s a really good form, it fits numerous functions with one design.

The second underlying idea is the relationship between efficiency and effectiveness. Sometimes things that are efficient are also effective, like the toucan’s bill or cactus shoots. But sometimes we are so focused on shallow, low-level definitions of efficiency—like speed—that we fall far short of the mark for deep, true effectiveness. For example, there is a small restaurant on Charles Street in Boston where seating is very limited. Instead of everyone rushing for the few empty chairs, the managers ask that you stand in line, order, and only take a seat once you have your food. This small adjustment is deeply uncomfortable for many customers: you can see the furrowed brows, the glances over shoulders, the occasional coat draped over a chair despite a large sign noting the seating policy. The desire to save a seat now is powerful, even though it’s not tied to an immediate need. This wait-and-sit approach seems inefficient but it is truly effective: there are exactly the right number of seats available at exactly the right time, resulting in near–100 percent occupancy. True, the seating process is not super-speedy. This is a more profound form of efficiency, optimizing time, space, and expense.

The final embedded concept is one of duration. Efficiency in a natural context takes a full-cycle, multidimensional view, unlike many human endeavors. If a new manufacturing process uses less material, but is much more energy intensive and leaves toxic by-products at the end, it is not in alignment with the resource-efficiency principle. Managing across many dimensions and multiple time frames is harder, for sure. To align fully with this principle we need to include elegant, multifunctional design; material and energy efficiency; recycled and recyclable materials; and fitting form to functions. This is a much more daunting task than just aiming for “cheap right now.” But if it’s harder, so what? As Jack Welch has said, we need to eat, and we need to dream.5 Or to quote my mom, “Honey, that’s why they call it work. It’s supposed to be hard.” Aiming for deep effectiveness does not offer shortcuts or partial credit: we need to embrace the nuance as much as the headline. We are all already functioning effectively across numerous settings, every day; as citizens, as businesspeople, as artists, as innovators, as family members, and yes, as investors. These natural principles acknowledge that multidimensional reality, and extend it into more realms of practice.

Figure 1–1 Resource and Energy Efficient: The Honeycomb

Sure, it is aesthetically pleasing, all of those hexagons arranged row by row, but these also are the most efficient shapes: hexagons use less material (and less energy) per unit of structural integrity than any other standard shape.

http://www.nature.com/news/how-honeycombs-can-build-themselves-1.13398

Translation to Investing

It’s tempting to claim that resource-efficient investing is already alive and well. For each of the efficiency subprinciples, plenty of financial illustrations come easily to mind. Take the fundamental building block of money—it is certainly multifunctional, able to serve as a store of wealth, a measure of transaction value, and, in hyperinflationary periods, as wallpaper. Additionally, there is almost no cost to trade securities these days—so surely that is a low-energy process. Speaking of securities, we are constantly trading and retrading the same ones—this seems to be recycling materials. And there are so many forms that investment can take, well, surely we can argue that its forms fit all sorts of functions.

Oh, but there’s the key. Function. What is the function of investing? What is its purpose? What constitutes truly effective investing—beyond a fast-and-cheap, shallow, transactional efficiency? What would an investment look like if it were aligned with all of the nuances of resource efficiency? A mismatch between investment form and function can have vivid and significant consequences.

For example, who can forget the famous Good Will Hunting scene, where Will out-quotes the obnoxious grad student and notes that the same education is available for a small expense in library late fees instead of thousands of dollars in tuition. The grad student sneers that that may be true, but at the end of his education, he’ll have a degree, unlike Will.6 And there you have it, the mega-question. What is the function of investing in education? To be educated, or to have a degree? If it’s the former, Will’s approach—investing time—is obviously the best fit, and the grad student is foolish to spend all that money. But if the degree is what’s valued instead, then those many-thousand-dollar tuition payments might indeed be a resource-efficient path.

So the real question we ask needs to include both function and context: what is the purpose of investing in this situation? For individuals, this can sometimes be answered in simple monetary terms, like, “I need income of $5000 per year from this investment.” Or it can be answered in multifaceted terms, such as, “I want to support my local agricultural community, and I need this money back in two years.” In some cases these answers reveal more complex personal priorities, like, “I need this money to buy a house someday, but I want to honor my aunt who was an anti-war protester, so I’d like to invest in a way that promotes peace.” You can see why we often avoid this kind of nuance in defining investment function: it’s much more difficult! But it’s more interesting, more true to life, and ultimately it can be more rewarding.

For investment professionals, the context may be different from an individual investor’s, and the answers may be even tougher to come by. If your firm is introducing a new investment fund, why? What need is it fulfilling? If the purpose is to grow your own business, that’s fine—just say so, and settle the surrounding questions of form and process accordingly. If the purpose is to provide a new or different service to your clients, why is that new service needed? What sort of form best fits that purpose? Perhaps the appropriate form is partnership with other providers, or use of processes that already exist elsewhere, rather than expending energy and expense in creating your own offerings.

Many of the biggest mistakes in the history of finance are rooted in misstated or made-up statements of need. Who needed tulip bulbs in 1637? Hardly anyone—or at least far fewer than the number who wanted tulip bulbs, which led to tulip mania and the subsequent crash, all out of alignment with principles of efficiency and effectiveness. Note that the definition of need is not required to be noble or righteous—just clear and true. And, most importantly, the needs can vary—there is not one single purpose for investing, nor should there be.

With a clearly identified need, it becomes much easier to find forms that fit, to see which materials will be best suited for the task at hand, and to ensure efficient, multifunctional design of investing approaches. Understanding purpose is the root of what takes us from merely fast and cheap to deeply efficient and effective.

Natural Scorecard: Investment Helpers

I’ve been thinking about these questions of purpose with respect to my parents and their retirement savings. If, at each step of the way, we were able to clearly assess need, form, and function, we would be unlikely to end up with a dozen different retirement accounts (or a dozen cans of tomatoes), all performing the same essential function. In the case of my folks, luckily, the duplication was benign: it added complication, but not significant cost or risk. But that’s not true for many investors, who often encounter waves of complications that have great big price tags attached.

Consider a plain-vanilla solution for many investors, the mutual fund. An actively managed fund has average fees of about seventy-seven basis points (bp) a year; this means you pay 0.77 percent of your money—$7.70 for every $1000 you’re investing—to the manager every year, whether performance is up, down, or sideways. An index fund is much lower cost, only thirteen basis points annually, but still, there is a fee.7 And what do you get for this fee? Well, you get professionals looking after your assets. You get accurate accounting and tax records. You get peace of mind knowing that others are worrying about the financial markets on your behalf. Alas, you do not get superior performance, at least not automatically; across all equity and fixed income categories, less than 50 percent of actively managed mutual funds have outperformed their benchmarks on a ten-year basis, and in some categories as many as 80 percent of funds underperform.8

Still, this might seem like a pretty fair trade—good service, diversification, and at least the possibility of superior returns, in exchange for modest fees. How does the mutual fund investment option stack up against the principles of resource efficiency?

• Does it use multifunctional design? Well, there is one major function—to act as an effective vehicle for investing—and mutual funds are well designed for that. Plus, you can use the same fund design for all sorts of investing—stocks, bonds, different regions, different-sized companies. But these functions are all very closely related—it’s not like preen oil for the duck, where it’s a moisturizer and water repellant and nutrient all in one.

• Does it employ low-energy processes? Pretty much—compared with investing your own time and energy, or much more complex investment schemes, mutual funds stack up pretty well. They are easy to use, and are adaptable with little extra energy required to adjust.

• Are all materials recycled? Hmm, in some ways. Components of mutual funds (individual stocks and bonds) are constantly being bought and sold, reconfigured in different combinations to produce full investment portfolios.

• Does it fit form to functions? Fairly well—the form is simple and fairly flexible. You can use it to invest in all sorts of different securities, and for all sorts of reasons. But these functions are all closely linked, as noted above.

In short, the answer to all of these questions is somewhere around a B or B minus. Simple mutual funds are aligned with resource-efficient principles, but in a pretty narrow way.

However, for many these days, mutual funds are considered child’s play—too basic for real, serious investors with real, serious investment objectives. Warren Buffett famously wrote about these investors and their waves of “helpers” in his 2005 annual report (that section of his report is titled, “How to Minimize Investment Returns,” so you can see where this is headed). Buffett tells of the fictional Gotrocks family, approached in succession by different sorts of financial helpers. First come the broker-helpers, followed by manager-helpers, followed by consultant-helpers, followed by hyper-helpers. Each layer of helper may be well intentioned, and may provide some value, but each also adds cost to the Gotrocks’ investment process, and in many cases this cost is far in excess of value received.9 This concern applies to institutional investors and their advisors as well as individuals.10

This might seem like a minor issue—what’s a few basis points in fees, especially if they bring added expertise and sound judgment to your investment process? Let’s add it up. Here is a quick and simple summary of the costs of complication for investors:

  • Index fund—just a mirror of securities that are in a particular index. Cost = 13 bp.
  • Actively managed equity mutual fund—“stockpicking” approach, a subset of securities that aims to outperform the relevant index. Cost = 77 bp.11
  • Fund of funds product—a bundle of different funds, usually with an extra layer of fees. Cost = 91 bp.12
  • Hedge funds—a particular kind of fund that has more investment freedom, and thus hopefully more chance to perform well. Cost = typically “2 and 20,” or 200 bp annually, plus 20 percent of gains.
  • Investment advisors—someone to help decide amongst the thousands of options available, with the aim of tailoring decisions to your own situation. Cost = 106 bp annually, on top of all of the product-specific fees noted above.13

This list does not include the even more convoluted options that are often used by high-net-worth individuals or institutions: funds of hedge funds, extra layers of investment consultants, and so on. And these fees are all annual fees, paid not just once, but every single year, regardless of performance.

There are plenty of times when these sorts of fees are justified: long-term investment performance could be great, or perhaps an investor really needs and values the assistance of an advisor. Perhaps you are investing for reasons that go beyond financial goals—such as improving the local food web or supporting new entrepreneurs—and the nonfinancial information and results that these advisors help to provide are well worth the fees involved. For the record, for many years I was a portfolio manager of actively managed equity mutual funds, and our goal was always to beat market (and thus index) performance, after accounting for all fees. As the chairman of our company used to say, “We are not here for our own amusement.” People were counting on us to steward their hard-earned savings in a responsible and effective manner. So the point is not simply to conclude “Fees are bad,” but rather to ask the more important questions, “What function is served by these fees? What value do they reflect?”

Even if great value is provided, the costs of investment fees can be tremendous. Say you invest $100,000 in an index fund for ten years at a fee of thirteen bp per year ($130 in fees for year one). If returns are 5 percent per year, at the end of the decade you have about $161,000—a total return for the decade of 61 percent. However, if you invest that same $100,000 in a hedge fund, your fees are two hundred bp ($2000 in year one), plus 20 percent of investment gains. If returns are 5 percent per year, the same as the index fund, at the end of the decade you have $122,000, a total return of just 22 percent for the whole decade. Put another way, because of the higher fees, returns in the hedge fund need to be about 8.5 percent per year in order for you to end up with the same amount of money as owning the index fund with performance of 5 percent. At the 5 percent performance level, you have paid $39,000 in additional fees over that time period for the hedge fund structure.

This quick exercise shows why road maps like natural principles are so useful—because our minds are not well suited to considering ripple effects and compounding.14 Even if we intellectually understand the facts about layers of fees, and even if we are great at doing compound math in our heads, 2 or 3 percent sounds small. Here’s the thing: a 3 percent chance of rain means near-certain sun, but a 3 percent investment fee could set you up for terrible storms. Our brains have a hard time distinguishing between these two very different contexts for “3 percent.”

An assessment of an “ultra-helped” investment model—one that uses complicated products and layers of advisors—against the principles of resource efficiency shows how it comes up short:

• Does it use multifunctional design? This sort of arrangement still serves the major function of investing, but it uses more and more products and inputs to serve the same purpose; this is the opposite of multifunctional design.

• Does it employ low-energy processes? As increasingly processed investments and more layers of advisors are added, energy use increases.

• Are all materials recycled? As with our mutual fund example, you could say that the components of these funds are often traded and reconfigured, but this remains a pretty narrow interpretation of “recycling.”

• Does it fit form to functions? The hyper-helped investing model is inherently more complicated than a simpler approach, and there is little evidence that it performs the essential investing functions better. This seems to be a situation of overengineering rather than a simple, elegant match of form to function.

As noted above, there are times when a complicated, multilayered investment approach might make sense, when it matches a similarly multilayered set of needs. But much of the time, this sort of highly engineered approach adds a lot of cost and complication while providing extra features that are not especially relevant, valued, or needed.

Here we come to an important distinction: complicated versus complex. In this context, the words mean very different things. A complicated system, or a complicated investment product, is just one that is hard to manage, or hard to explain. It’s difficult, but it’s predictable. A complex system, on the other hand (more precisely, a complex adaptive system), is comprised of heterogeneous, connected parts that interact with one another in unpredictable ways and change over time. Therefore, the whole system cannot be described just by summing up the individual pieces; as a collective, the system shows emergent properties that make it hard to link cause and effect in a simple, linear way.15 Think of a beehive: each bee is performing tasks that are describable, definable, and maybe even predictable. But adding up the actions of each individual bee does not even begin to describe the function of the entire hive. A group of individual bees is complicated; a whole hive of bees working together is complex.

There are two reasons why this difference between complicated and complex is so important for thinking about effective investment practices. First, we often take a simple need and match it with a complicated solution or product. Someone just wants to save money for college tuition and before you know it, they are invested through three layers of advisors in a fund of funds, paying 2 percent in fees, when they could fulfill the same essential purpose for one-tenth the cost. The solution is overengineered when compared with the simple function that is required.

Second, we often mistake complex situations for complicated ones. This sort of mistake can be more than costly; it can be devastating. These days we often do have genuinely complex investment needs: trying to mitigate risk for a big global portfolio that has ever-changing and unpredictable correlations within it, for example. We have tried to address complex purposes like this one by just throwing more complicated solutions at it. That’s like performing highly technical heart valve surgery on someone who has a broken heart of an entirely different sort. Neat technology. Same general location. Totally wrong application. You will never solve the problem this way, just like you will never understand a beehive by watching individual bees. The form does not fit the function.

Evolution

Fortunately, there are increasing examples of reconnecting investing needs with simple, elegant, direct solutions. For example, peer-to-peer lending eliminates several layers of intermediaries by allowing more direct forms of loan making. To be sure, this comes with different characteristics than a neatly bundled-up investment product, including different risks, but it also offers more direct connection between investor and investee, which might well make it more aligned with the principles of resource and energy efficiency. Think about it—all of the resources saved by not having three or four sets of institutions involved in bundling up the loan (low-energy processes), a platform that can serve the needs of many different lenders and borrowers at once (multifunctional design), and a directness that allows for straightforward and simple transactions (fit form to function). The modern incarnations of peer-to-peer lending are in their infancy, but these are really new tools that extend an old concept, one seen in villages and religious communities and amongst friends and family for centuries. It’s the idea of lending to people you know, combining financial risk with social assets, in a way that contributes to your own community. Simple, elegant forms of investing.

Other examples of effectiveness can be found in the field of impact investing. Because impact investors are actively seeking multidimensional returns (beyond just financial returns), established investment “boxes” don’t always fit. Consequently, many endeavors end up being very difficult to manage, with reams of legal paperwork and creative but complicated structures. However, organizations like RSF Social Finance, the Calvert Foundation, and TriLinc Global are offering investment options that streamline those piles of paperwork, meeting multiple functions (financial benefit, social benefit, community connection) in a way that aims to be less complicated, less costly, and more effective for their investors.

Pathway to Practice

What is real efficiency? It’s not just cheap and fast. Deep efficiency—natural efficiency—includes complete views across a system and across a life cycle. Instead of asking whether an investment is easy to make, back up and ask, what purpose is this investment serving, and what form best matches that purpose? Then look around and ask, am I duplicating this function? If so, am I adding meaningful diversity, or just expending extra energy and resources by doing the same thing twice?

Once we’re comfortable asking these questions about a specific investment, we can extend them to consider investing in its broader form. What are the key functions of all of your investing, whether you’re investing time, money, or energy? Are the forms you’ve chosen efficient in a deep way, or just fast and cheap? Are there more creative solutions than the ones you’ve chosen, solutions that perform multiple functions and use fewer resources?

Our current investment culture values efficiency, but often we think of its shallowest form, merely quick and inexpensive. We can reorient this value toward its deeper form of true, systemic efficiency—real effectiveness.

If we’ve been solving investment puzzles by just trying to run faster, or by throwing more and more resources at the same type of solution (as in our ultra-helper model), we can pause to reconsider. What is the real intention of our activity? What functions are we trying to perform? And what forms best match those functions? Perhaps a simpler, more truly efficient form is all that we need, despite the allure of new layers and innovations.

In the end, my parents’ choice of plain old Treasury bills and certificates of deposit at their local bank served their purpose quite well for many years, and did so in a simple, resource-efficient way. These investments did not make for good cocktail-party chatter; they are dull as dirt. But my folks were clear on the function they wanted to perform. They just wanted to save some money for retirement, not to engage layers of helpers, not to invest in currency swaps or Brazilian real estate, not to have cool stories to tell their friends. That clarity, and the efficient match of form and functions, has stood them in good stead.

Sowing Seeds of Resource-Efficient Investing

Here are some simple ideas to start us along a deeply efficient path:

• Clarify the underlying functions performed by your investments: is it financial return? What sort? What time frame? Is it other sorts of return? Social benefit, community building, personal or organizational connections? Nature does not falsely settle on a single function, and neither should we.

• Acknowledge that more help and more resource intensity aren’t always needed—or even beneficial. Many of our investment processes include an embedded assumption that more is always better—bigger teams, more expertise, greater infrastructure. But natural systems use the appropriate level of resources and energy, not the maximum. Sometimes the appropriate level of complication is high, but often it is low.

• Invest with a goal of fitting form to functions. Aim for a clear match of form and function, not the fanciest, most innovative, most clever, or most popular possibility.

By more fully acknowledging the importance of resource and energy efficiency in our investments, we can identify the investment equivalent of the duck’s preen oil or the toucan’s bill. We can eliminate needless complexity and focus our energies on areas where the extra effort is needed and beneficial.

We can move from shallow efficiency to deep effectiveness.