Jump to content

How do you figure out what you don't know in investing?


LongHaul
 Share

Recommended Posts

How do you figure out what you don't know in investing? 

 

I have found over the years that even after a lot of work I can still not understand a key overriding consideration of a business.

I think it was Walter Schloss who said that you have to own a business to really understand it. 

 

Here are 3 types.  I am really interested in type 3, as that is what is more controllable and can cause losses.

 

1.  Unknowns that are identified previously.

2.  Random Unknowns.

3.  Unknowns that are due to ignorance.

 

 

Link to comment
Share on other sites

Depressing topic.  ;)

 

Every time I look at any investment I hold or don't hold, I think that I don't know enough. Even more depressing is that I think I won't know enough even if I spent more time on studying that particular company/business/business area/etc.

 

Your quote of Walter Schloss might be right - it's tough to understand a business you invest in without owning a business outright. Buffett/Munger make the same point.

Link to comment
Share on other sites

Posted a thread about this some year ago.. still trying to figure it out and its a slow process..

 

You know when buffett said.. "investing is part art part science" but he never mentioned in my knowledge details about the "parts"... so how much is part art ? and how much is part science..?

 

As I get older, the part art is becoming increasingly larger because it includes many more dimensions and thus logically it is where I should put my focus which imo goes hand in hand with schloss view that you have to own a business to really understand business dynamics: the culture, the product, the dealer, the employed, the leaders, the margins, the marketing, the consumer, the economic environment and so on..

 

That is why if you can understand how a business is built from the inside, it is easier to understand the problems it may face from the outside and thus makes it less of a problem to put a price on it.. This is also why I believe the circle of competence is much smaller than many people think because no two businesses are ever the same even if it looks like it on paper..

 

"Diversification is a protection against igonrance, It makes little sense if you know what you are doing."

 

For your third point I am following the advice from Buffett to deal with ignorance: Write down on paper why you are buying the business, what could go wrong, the ifs and buts, how the CF move, how the margins are created and so on.. and if you cant apply it pencil to paper then you should think it through some more.. I believe that if one really does that process, many would be surprised on how little of that paper that gets filled and their igonarance would be illustrated by themselves.. at least that was what happend to me first time I started doing it..

 

Best Regards,

Link to comment
Share on other sites

Unknown unknowns are the toughest.  But another trap you can find yourself in, as I did, is thinking you have to know everything.  You can read every book ever written about investing, and scrutinize every page of a 10k, but at some point, nothing can replace good old fashion experience.  When you're in the game, you quickly learn what the most important variables are and what is really just noise. 

 

Think about the returns Buffett, and others, put up when they were in their twenties.  Even though he knew a fraction of what he know's today, he was still able to generate great returns. 

Link to comment
Share on other sites

The easiest way is to post your analysis on an investment on this message board and let others rip it to shreds.  :)

 

Seriously, we have to let others do that in order to see areas that we are blind in.  The challenge is that not all criticism is sound.  The one giving the critique may have their own blind spots. I would suggest finding someone and doing it privately.

 

 

Link to comment
Share on other sites

Unknown unknowns are the toughest.  But another trap you can find yourself in, as I did, is thinking you have to know everything.  You can read every book ever written about investing, and scrutinize every page of a 10k, but at some point, nothing can replace good old fashion experience.  When you're in the game, you quickly learn what the most important variables are and what is really just noise. 

 

Think about the returns Buffett, and others, put up when they were in their twenties.  Even though he knew a fraction of what he know's today, he was still able to generate great returns. 

 

I noticed in the employment/training survey a few months back that some 50% of the membership were engineers.  My observation is that engineers need to know everything, and experience discomfort with uncertainty. 

 

As outside passive minority investors we know barely more than nothing.  And thats all we will ever know regardless of the amount we read.  Take any financial institution.  The CEOs and CFOs of most of these companies dont know the entirety of their operations, let alone on a daily basis, and they have worked there 12 hours a day for decades, often: Ie. Jamie Dimon.  But he, and I understand that in aggregate, if JPM keeps doing what its doing and incrementally adapting to new situations the stock will do well, if bought at a low price. 

 

Even really simple businesses like pulp and paper, or lumber, have enormous amounts of moving parts these days, hedges, currency issues, cyclicality, supply/demand imbalances, technology costs and issues. 

 

It is more art than science in the end.  Walter Schloss was successful because he stuck to a system that worked, at that time.  His system was light on research but tough on inclusion criteria.

 

My best investments have been those I have held for awhile.  I get to know them over time.  Obviously, the less successful ones I give up on.  Now, I deliberately try to hold onto those I have held because I have some basic understanding of the company, and some comfort with management (really critical). 

Link to comment
Share on other sites

I think Tim's suggestion is good one. Find your personal Charlie if you can.

 

BTW, this is true for a lot of other endeavors: find a friend/colleague who is good to brainstorm/discuss/get feedback from. Someone who matches what you're looking for when discussing things and yet can give a good valid criticism. It's not trivial to find such person. If you find them, they are worth the weight in gold. :)

 

Another note though: investment like writing novels is not physics: there's a lot of subjectivity and thesis that works for one person might not work for someone else. It's easy to destroy any thesis in general or at least imagine outcomes that would destroy the returns. Since humans are not good in guessing/assigning probabilities, these outcomes may or may not really hurt estimated returns. Most discussion even on this board does not go into "Outcome X has Y% chance, outcome Z has W% chance, so your return will be approximately U%". People will rather say "Oil will go down, Google will enter the market, Bank of Japan will devalue the yen and so your investment will lose". I am exaggerating a bit, but ultimately very few discussions go really deep even the ones with 100+ pages of comments. And this is partially understandable, since, as I said, assigning probabilities is very hard if not impossible. That's another part of difficulty.

Link to comment
Share on other sites

This is exactly why I don't lose sleep trying to read every shred about a company or "understand the business" because we never will unless we own it.

 

As an outside passive investors we are playing a game of probabilities.  If you buy at a low enough value to *something* there is a greater chance of it being worth more in the future compared to being worth less.

 

I like to own more than a handful of companies to spread out the probabilities.  Some risks I won't see coming, I want to minimize the outcome when that happens.

 

As long as humans with emotions work at companies there will be risks.  No one is really rational.  Perfect example; a client of mine, a multi-billion dollar company had a CEO fly off the handle.  He was sleeping with a secretary and accused her of cheating on him with her husband (take a second and ponder that..).  Went to their house on a weekend and beat up the husband and told the police "If you hadn't arrived I'd probably have killed him."  You can't know about these things ahead of time as an outsider.  As an insider you might have a sense it's possible.

Link to comment
Share on other sites

Great topic, very thoughtful responses as well.

 

I've been thinking about the topic generally (called the Dunning Krugger effect, the unknown unknown, great article here http://opinionator.blogs.nytimes.com/2010/06/20/the-anosognosics-dilemma-1/?_r=0  (Wherein the more experienced admit to their ignorance and the less,  well I won't spoil the punch line.)

 

As long as humans with emotions work at companies there will be risks.
So true.

 

As is this:

Most discussion even on this board does not go into "Outcome X has Y% chance, outcome Z has W% chance, so your return will be approximately U%". People will rather say "Oil will go down,

 

  Now, I deliberately try to hold onto those I have held because I have some basic understanding of the company, and some comfort with management (really critical). 
and you get the power of compounding!

 

nothing can replace good old fashion experience
I would add temperament.

 

It's why you MUST have a margin of safety.

 

And as Munger says, you have to be a learning machine.

Link to comment
Share on other sites

Unknown unknowns are the toughest.  But another trap you can find yourself in, as I did, is thinking you have to know everything.  You can read every book ever written about investing, and scrutinize every page of a 10k, but at some point, nothing can replace good old fashion experience.  When you're in the game, you quickly learn what the most important variables are and what is really just noise. 

 

Think about the returns Buffett, and others, put up when they were in their twenties.  Even though he knew a fraction of what he know's today, he was still able to generate great returns. 

 

I noticed in the employment/training survey a few months back that some 50% of the membership were engineers.  My observation is that engineers need to know everything, and experience discomfort with uncertainty. 

 

 

 

uccmal, I strongly disagree with that statement. Engineers (and I am one) have the task of making something work, they do that well. If something works well, their job is done, they don't stop and ponder, oh why does it work? my formula says its shouldn't!  Case in point is flying, the wright brothers made planes that flew, yet to this day there is argument as to whether it is the shape of the wings that makes planes fly, but boeing and airbus keep cranking out better and better planes, because it doesn't matter what is the physics behind it!

 

The people who have to understand everything are scientists and there it gets dangerous in investing, the best example is derivatives and the black-scholes formula.

 

I think engineers make good investors because they have good understanding of probabilty, probability theory is requirement in all undergrad engineering courses

Link to comment
Share on other sites

Instead of trying to figure out what you don't know you could also entertain a slightly different viewpoint: how do I not get killed by what I don't know? The more you expect you don't know the more you should diversify. Unfortunately it is hard to judge your own (lack of) knowledge - which suggests you should diversify.

Link to comment
Share on other sites

I think it was Walter Schloss who said that you have to own a business to really understand it. 

 

I remember Schloss's point with a somewhat different nuance (can't find the particular interview with the exact words right now).  As you know, he frequently bought a baby position just from the Value Line data, and only AFTER buying, he would order the 10K annual reports to look a little deeper.  If he liked it and understood it better, he might buy more.  I recall his words to the effect that you pay better attention when you own the stock.  But this method suggests Value Line-type of data is sufficient, when combined with wide diversification. 

 

(He may also somewhere else have made the point about knowing a business per se, as opposed to it's stock.)

Link to comment
Share on other sites

Isn't the bigger issue:

 

“It's not what you don't know that kills you, it's what you know for sure that ain't true.”  ;D

 

Is that right?

 

Well, I can't remove what I don't know. But I can sure remove what I know for sure. From now one, I will never say I am never sure of anything.

 

 

Link to comment
Share on other sites

How do you figure out what you don't know in investing? 

 

I have found over the years that even after a lot of work I can still not understand a key overriding consideration of a business.

I think it was Walter Schloss who said that you have to own a business to really understand it. 

 

Here are 3 types.  I am really interested in type 3, as that is what is more controllable and can cause losses.

 

1.  Unknowns that are identified previously.

2.  Random Unknowns.

3.  Unknowns that are due to ignorance.

 

You can instead take the approach of Buffett. The vast majority of the businesses that Buffett bought, are resilient to all three items you mentioned above. A CEO having an affair or worse do not impact the valuation of most of the businesses in Buffett's portfolio.

 

I do not think Buffett knows the in's and out's of Wells Fargo's or Bank of America's each operation in depth at the division level, and I do not think such knowledge is needed or necessary to invest successfully. Look at his definition of understanding a business and it tells a lot about what he focuses on:

 

"It's a question of being able to identify businesses that you understand and you are very certain about. When I say understand–my definition of understand is that you have to have a pretty good idea of where it's going to be in ten years. I just can't get that conviction with a lot of businesses, whereas I can get them with relatively few. But I only need a few–six or eight, or something like that."

 

or look at his definition of risk

"We think first in terms of business risk. Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there's a hiccup in the business, then the lenders foreclose. It can come about by their nature –there are just certain businesses that are very risky. We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise. The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation. Then the risk becomes the risk of you yourself –whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market."

 

I think it is better for us also to focus on such businesses where we are less exposed to risks you mentioned.

 

Sorry for tossing Buffett quotes, you probably know most of these by heart, but they covey the message better.

 

Vinod

Link to comment
Share on other sites

Unknown unknowns are the toughest.  But another trap you can find yourself in, as I did, is thinking you have to know everything.  You can read every book ever written about investing, and scrutinize every page of a 10k, but at some point, nothing can replace good old fashion experience.  When you're in the game, you quickly learn what the most important variables are and what is really just noise. 

 

Think about the returns Buffett, and others, put up when they were in their twenties.  Even though he knew a fraction of what he know's today, he was still able to generate great returns. 

 

I noticed in the employment/training survey a few months back that some 50% of the membership were engineers.  My observation is that engineers need to know everything, and experience discomfort with uncertainty. 

 

 

 

uccmal, I strongly disagree with that statement. Engineers (and I am one) have the task of making something work, they do that well. If something works well, their job is done, they don't stop and ponder, oh why does it work? my formula says its shouldn't!  Case in point is flying, the wright brothers made planes that flew, yet to this day there is argument as to whether it is the shape of the wings that makes planes fly, but boeing and airbus keep cranking out better and better planes, because it doesn't matter what is the physics behind it!

 

The people who have to understand everything are scientists and there it gets dangerous in investing, the best example is derivatives and the black-scholes formula.

 

I think engineers make good investors because they have good understanding of probabilty, probability theory is requirement in all undergrad engineering courses

 

Your spoiling my fun....  I have spent my life razzing engineers and their models.  I once sat in a construction trailer for hours with a group of engineers who were debating the operation and construction of a unit 50 feet away.  Eventually, a pipe fitter/plumber suggested they go out and actually look at the process.

 

I agree on the academics though.  Black-Scholes is an abomination but others use it, therefore understanding it helps us get better deals.  Same with technical analysis. 

Link to comment
Share on other sites

How do you figure out what you don't know in investing? 

 

I have found over the years that even after a lot of work I can still not understand a key overriding consideration of a business.

I think it was Walter Schloss who said that you have to own a business to really understand it. 

 

Here are 3 types.  I am really interested in type 3, as that is what is more controllable and can cause losses.

 

1.  Unknowns that are identified previously.

2.  Random Unknowns.

3.  Unknowns that are due to ignorance.

 

You can instead take the approach of Buffett. The vast majority of the businesses that Buffett bought, are resilient to all three items you mentioned above. A CEO having an affair or worse do not impact the valuation of most of the businesses in Buffett's portfolio.

 

I do not think Buffett knows the in's and out's of Wells Fargo's or Bank of America's each operation in depth at the division level, and I do not think such knowledge is needed or necessary to invest successfully. Look at his definition of understanding a business and it tells a lot about what he focuses on:

 

"It's a question of being able to identify businesses that you understand and you are very certain about. When I say understand–my definition of understand is that you have to have a pretty good idea of where it's going to be in ten years. I just can't get that conviction with a lot of businesses, whereas I can get them with relatively few. But I only need a few–six or eight, or something like that."

 

or look at his definition of risk

"We think first in terms of business risk. Business risk can arise in various ways. It can arise from the capital structure. When somebody sticks a ton of debt into a business, if there's a hiccup in the business, then the lenders foreclose. It can come about by their nature –there are just certain businesses that are very risky. We tend to go into businesses that are inherently low risk and are capitalized in a way that that low risk of the business is transformed into a low risk for the enterprise. The risk beyond that is that even though you identify such businesses, you pay too much for them. That risk is usually a risk of time rather than principal, unless you get into a really extravagant situation. Then the risk becomes the risk of you yourself –whether you can retain your belief in the real fundamentals of the business and not get too concerned about the stock market."

 

I think it is better for us also to focus on such businesses where we are less exposed to risks you mentioned.

 

Sorry for tossing Buffett quotes, you probably know most of these by heart, but they covey the message better.

 

Vinod

 

I actually didn't know these ones.  The concept of being able to visualize where a business will be in ten years is very valuable, even if you have no intention of holding it ten years.  Would have saved me from botch ups like Yellow pages, sfk, and RIMM.  This seems really important in this era of creative destruction.

Link to comment
Share on other sites

You can instead take the approach of Buffett. The vast majority of the businesses that Buffett bought, are resilient to all three items you mentioned above. A CEO having an affair or worse do not impact the valuation of most of the businesses in Buffett's portfolio.

 

Sorry, but this is not true. Please read "Snowball". Buffett has fired multiple CEOs because they underperformed. Including 2 CEOs of KO via backroom deals. So CEOs "having and affair or worse" do impact performance of even KO. And KO is not an exception, this has happened with multiple businesses Buffett invested in.

 

I also think that Buffett is deluding himself if he thinks that he knows where IBM will be in 10 years. But that's perhaps different discussion. :)

Link to comment
Share on other sites

Isn't the bigger issue:

 

“It's not what you don't know that kills you, it's what you know for sure that ain't true.”  ;D

 

Nice soundbyte, but I don't think that I was ever killed in investments by "what you know for sure that ain't true".

Link to comment
Share on other sites

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account in our community. It's easy!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now
 Share

×
×
  • Create New...