This quote comes from Charlie Munger; a great investor and deep thinker which initially seems contra intuitive.
Surely the more one knows the wiser one is; it’s the rationale for trusting in a professor, surgeon, priest or lawyer; they can tell us what is right and true because they are wise and knowing.
The challenge humans face, which as far as we know is unique on earth, is that we alone have the ability to make choices. All other creatures at least appear to be habitual, that is to say they are pre-programmed to act and interact in consistent pre-set ways.
The consciousness of thought and deed in humans is perhaps both our gift and our curse, creating the agony of choice, the complication of anticipating and calculating the interaction between our actions and their resultant reactions.
Some mitigate this by becoming habitual (doing the same thing repeatedly without thought), most follow the lead of those who appear successful either historically or in the moment and a few, patiently, cumulatively, at best partially, work out how things fit together and attempt to navigate a pragmatic course predicated on a structure of time tested values.
So Charlie’s observation speaks both to the desire to balm personal anxiety with the illusion of certainty, and additionally to be perceived by others as a wise and knowing individual.
In the area of investment those that appear for a time to consistently make the right moves are lauded and their words and actions are voraciously analysed and imitated.
There are however many examples of such people who have periods of great success only then to fall spectacularly back to earth having flamed out. These Icarus like events cause much hand wringing – why has this happened? Were they false idols? What changed?
To explain this phenomenon Warren Buffett tells the story of a worldwide competition for which 1000 people are randomly selected to compete in a heads and tails championship.
The rules are simply: throw a head, advance to the next day, throw a tail and be eliminated.
Now by simple probability roughly half the contestants will throw a tail each day so after the first day 500 people will be out, the second day a further 250 will go home and on day 3 another 125 etc.
By the end of the first week there will be around 8/10 players left (this is just maths) all having tossed 7 heads in a row. The way human perception works however, this will appear to many to be a pretty amazing achievement, ‘what are the chances of doing that?’
These people will start to be asked onto chat shows and several will commence writing books explaining their technique and skill.
Finally by day 10/12 there will be a winner, the man or woman that threw 10/12 heads in a row. The words of this person will from then on be pored over for wisdom and insight for they must be knowing!
What don’t we know
At face value thinking about what we don’t know appears fairly pointless.
For instance I don’t know next week’s lottery numbers; I am aware that I don’t know the numbers but what help is this to me?
Sir John Templeton made a well-known observation about achieving investment success.
He said it is only possible, logically, to be above average if you didn’t do what the majority are doing.
Being one of the majority, by definition and mathematics, must result in being average.
Another of Charlie Munger’s often articulated themes is the practice of Inversion thinking (invert – always invert, he recommends).
What he means by this is think as others are not; look at facts in a contra intuitive fashion.
So if we invert the conventional wisdom of “we must know more to be successful”, the resultant conclusion is that if we believe we know less, then to succeed is to accept we don’t know everything and to pare down our actions to those things which evidentially we can verify.
To put it another way, the majority will desire to believe they know what will happen in the future (and this is illusionary).
So if instead one focuses on what can be determined as very unlikely to happen, (because it never has or, to identify what can’t be good because it’s clearly broken and can’t be fixed) then results are not going to be average.
To give a simple example to this.
Many recommend that the most effective way to invest is via an index tracking fund (FTSE100).
The rationale for this is it’s very difficult to consistently pick the winners so don’t try.
If this is “inverted” however the reality is that achieving better performance than the index does not always mean picking all the winners, but predicting a better future result for say 20 companies in the index than is currently perceived could garner better than average results.
Out performance can equally be achieved by simply not investing in the worst 20 Companies that are plainly in trouble and will do badly.
If you think about this, it’s much the easier option, the problems are quantifiable, the potential solutions can be modelled and the odds of success or failure can be calculated.
So by knowing that you can’t know the future, but knowing what you can know in the moment (and its likelihood of changing in the foreseeable future) and making probabilistic investments based on these calculations, the chances are far higher that successful outcomes will on average be achieved.
There are a number of similar examples of investing in assets where, ‘what can be known’ is used to evaluate its attractiveness.
Value: Buying investments at a price lower than the value of its assets
Emotion: Buying fundamentally financially sound investments where sentiment is negative
Mean Reversion: Knowing that the stampeding herd will return to pastures it currently ignores.
All the above are examples of an individual investor who knows that the herd doesn’t know what they think they know, and eventually the herd will change its mind.
Unfortunately although the above is broadly true (by the evidence) in and of itself it does not guarantee success.
As Keynes famously said, “markets (the majority) can stay irrational (retain beliefs unsupported by the facts) longer than an individual can stay solvent.
In parenting terms teenagers stay teenagers longer than parents can stay patient and sane!
The final key ingredients to successful investment therefore are:
1. Always retain spare capital (solvency)
2. Know that in the words of the Buddha “all things will change, there is no state of permanence” we just can’t know or predict when it will happen
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.