The road to investing wisdom begins with ‘I don’t know’

MANY people think that investors fail because they do not know enough. I beg to differ. In my experience, it is our ego that blinds us and makes us do stupid things.

Mark Twain said it best: “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” We often make mistakes because we are too confident in our knowledge. And it gets worse when we find out that we were wrong.

That is why, as investors, one of the first things we should admit is simply: “I don’t know.”

Your circle of competence: Knowing what you don’t know

When it comes to buying stocks, investor and mutual fund manager Peter Lynch has a simple mantra: Invest in what you know. But what does it mean to know something? How do you gauge your knowledge and skills?

Businessman and investor Warren Buffett has a useful concept for this conundrum: your circle of competence. In layman’s terms, it refers to the range of topics and fields that you can understand well.

For instance, if you are a teacher, you will have a better understanding of the education system than most people. Likewise, if you are a restaurant owner, you will know the ins and outs of the food and beverage industry.

Here is what investors miss: Knowing what you are good at is just the beginning. The real challenge is to know your limits. You need to be honest about your weaknesses, and avoid investing in areas that you do not understand, Buffett says. In other words, you need to know what you do not know.

Do not worry about the size of your circle of competence; it does not matter how big or small it is. What matters is that you know where your circle ends – that is vital. You will find out the hard way when your stock drops.

If you lose confidence in your investment every time you hear some news, you may need to rethink what you know and what you do not know.

It is better to admit early that you are out of your depth than to suffer months and years later from holding the wrong stocks. Even a winning stock will be useless if you lack the conviction to hold it.

Discounting what you do not know

Speaking of conviction, the discounted cash flow (DCF) analysis is a popular tool among investors. It is not hard to see why. With a few inputs, you can calculate the value of a stock down to decimals. Having a target price is reassuring as it puts a number on when you can buy or sell your shares.

But do not be fooled by its precision. Financial media website Investopedia says a DCF analysis determines the value of a stock today, based on how much cash the underlying business will make in the future. Therein lies the flaw.

In effect, you need to guess how much cash flow a business can generate over, say five years, to be able to know what its value is today. That is, you need to divine the future to calculate the stock’s current value.

It is not as easy as it sounds. Try asking any chief executive officer today if they can tell you with certainty what their business will be worth in five years. Most of them will fail – and it is not for the lack of knowledge. Simply said, there are far too many factors which are beyond the CEO’s control.

So, if senior executives who have extensive knowledge of their business cannot get it right, you should admit that you also cannot do so. You are better off following the development of the business as it unfolds, and investing in stages.

Mr Market knows more than you expect

When the stock market falls, it can serve up bargains which are too good to pass. However, do not go on a shopping spree just because prices are low.

Ben Graham, the father of value investing, used a story to explain how the stock market works; he called it Mr Market. A friendly guy, Mr Market always tells you the price of your shares every day. But there is a catch: He is also very emotional. He often gets too excited or too depressed, and gives you prices that are too high or too low.

The trick is to know when Mr Market is wrong. That is how you beat him at his own game. Then again, while Mr Market has mood swings, he is not dumb. Even Graham admits that Mr Market can get it right sometimes, giving you a fair price for your stock based on how the underlying business is doing and its prospects.

The trick, then, is to realise that while Mr Market is not stupid, he is impatient. In the short term, he will change the price of your stocks to reflect the prevailing business news.

Over the long term, however, it is the business’ earnings growth that will determine the direction of the stock price.

As Lynch puts it, when measured in months, there is little correlation between a company’s results and the success of its stock. Over the long run, he says, there is a 100 per cent correlation between the success of the company and its stock price.

Concentrated ignorance

Buffett once said that diversification is for people who do not know what they are doing. But you are not one of them, are you?

Here is what I have noticed: Most investors do not like to admit that they need to diversify to lower their risk. They prefer to follow Buffett’s advice and put all their eggs in one basket. They would hold no more than five stocks at a time, sometimes even less.

Sadly, these same investors are just trading one flaw for another – ignorance for arrogance. Holding a few stock positions implies you have the rare ability to pick winners with atypical accuracy. Buffett, with his decades of experience, can make that claim. How about you?

In my mind, most investors are better off holding more positions until the time they have built up enough knowledge and expertise to handle owning concentrated stock positions.

It is okay to admit that you do not know everything. If you are too proud to admit that, you will end up losing a lot more.

Get smart: From know-it-all to learn-it-all

There is a reason why the stock market is called the Great Humiliator. Even the best investors, including Buffett and Lynch, have made mistakes.

Investor, hedge fund manager and author Seth Klarman said it best – that when you buy a stock, it is an arrogant act. You are saying you know more than the person selling the stock to you. That is arrogance.

There is no thin line between arrogance and confidence. They are both sides of the same coin. But here is the good news. You do not have to be stuck on one setting. You can be confident when you buy stocks. And then be humble after you buy the stock. You can commit to learning about the business over years, and earn your right to be confident.

It all starts with three simple words: “I don’t know.” That is the first step on the road to investing wisdom.

The writer is co-founder of The Smart Investor, a website that aims to help people invest smartly by providing investor education, stock commentary and market coverage