A successful fund manager once told me that investors need to “work with uncertainty”. The irony is that this is the opposite of how most people invest. Instead of embracing uncertainty, they look for certainty in all of the wrong places. For example, they:
- Rely heavily on “expert” advice.
- Look to history for an answer.
- Use complicated financial and statistical models.
- Avoid investment risk altogether (the proverbial “cash under the mattress”).
- Minimise regret by copying other investors.
Most investors will go to great lengths to avoid the feeling of uncertainty. An extreme example is the behavioural research cited in The Economist article Not so expert.
The remarkable tendency for individuals to rely on expert advice, even when the advice clearly has no useful component, was neatly illustrated in a recent academic paper about an Asian experiment. Undergraduates in Thailand and Singapore were asked to place bets on five rounds of coin flips. The participants were told that the coins came from fellow students; that these would be changed during the process; that the coin-flipper would be changed every round; and that the flippers would be participants, not experimenters. Thus there was a high likelihood that the results would be random.
Taped to the desk of each participant were five envelopes, each predicting the outcome of the successive flips. Participants could pay to see the predictions in advance, but they saw them free after the coin toss had occurred.
When the initial prediction turned out to be correct, students were more willing to pay to see the next forecast. This tendency increased after two, three and four successful predictions. Furthermore, those who paid in advance for predictions placed bigger bets on subsequent coin tosses than those who did not.
So ingrained is the desire to reduce uncertainty that even educated people will seek out advice on how to flip a coin – the standard academic example of a random event!
The article offers a possible explanation for such irrational behaviour:
There may be another, psychological, reason why investors want to pay for advice: the avoidance of regret. If you choose to put all your money into technology stocks on the back of your own research, and such stocks collapse, you only have yourself to blame. But if you have listened to the advice of an expert, then the decision is not your fault.
The comfort to have an expert on hand to blame in case of emergency is especially tempting for institutional investors with a fiduciary duty. If something ever goes wrong, a fiduciary can hopefully demonstrate to the regulator or a court of law that they acted as a “prudent man” or “reasonable person” would act when making decisions under uncertainty – by asking an expert.
Whether or not we are fiduciary investors, the truth is that most people find uncertainty to be deeply uncomfortable.
… Perhaps the financial-advice industry survives because the idea that the future is unknowable is just unsatisfying. Some forecast—any forecast—is therefore comforting. Mr Tetlock suggests that “we believe in experts in the same way that our ancestors believe in oracles; we want to believe in a controllable world and we have a flawed understanding of the laws of chance.”
Rather than fall prey to our instincts, we need to find a way to “work with uncertainty”. Remember, every other investor hates uncertainty just as much, if not more, than we do. If we can “work with uncertainty” by learning to control our reactions to the unknown, we put ourselves in a better position to profit from the irrational mistakes of other investors.
Essentially, this involves being honest with ourselves by recognising that we don’t really know exactly how any investment will turn out in the future. We can’t know because the future hasn’t happened yet. And if we could know, it would mean that the information would already be reflected in the price, meaning that we couldn’t profit from that knowledge. So we shouldn’t try to analyse the future as if it’s already taken place!
Comfortingly, investors don’t need to know what will happen in the future to make money and to be a successful investor. Instead of forecasting or relying on history, investors can use current information to imply a range of future investment returns (see tips below). They can then use these implied returns to decide whether or not an investment offers a suitable return and a sufficiently large margin of safety.
Importantly, by using current information to work out implied returns investors avoid both extrapolating recent history into the future and making educated guesses that have a low probability of being right. In other words, implied returns are a statement of the return and risk – or value – available to investors, now.
This remainder of this post is divided into two parts. The first part outlines what I believe to be the appropriate epistemology of investment. The second part lists several tips that I’ve found make it easier to work with uncertainty.
Part 1 – Puzzles and mysteries
US national-security expert Gregory Treverton made a distinction between two types of questions, which he called puzzles and mysteries. A puzzle is solved by acquiring more information. Each new piece of information collected makes the puzzle easier to solve. As Treverton observed, “Even when you can’t find the right answer, you know it exists. Puzzles can be solved; they have answers.”
A mystery can’t be solved by acquiring more information. If it did, it wouldn’t be a mystery. Mysteries don’t have definite answers. As Treverton explains, a mystery “poses a question that has no definitive answer because the answer is contingent; it depends on a future interaction of many factors, known and unknown… A mystery is an attempt to define ambiguities”.
For example, calculating the earnings per share (EPS) of the S&P 500 is a puzzle. First we collect the EPS data for each of the 500 companies in the index. Next we calculate the index weight for each of the 500 companies in the index. Finally we multiply each company’s EPS by its index weight and add all of the results together. By collecting 1000 pieces of information and performing a few calculations we’ve solved the puzzle.
On the other hand, finding out when and by how much the US Federal Reserve Bank will raise interest rates, let alone what the impact of the decision might be on asset prices is a mystery. The answer depends on so many things, most of which are uncertain and unknowable because they have yet to happen.
The distinction between puzzles and mysteries is an important one. If you believe the future is a puzzle, then the obvious way to solve it is to hire more researchers, collect more data, perform more analysis and make more predictions. In short, for puzzles, more is always better.
If you consider the future to be a mystery, though, you’d have to wonder whether adding to the volume of information will only make it more difficult to invest. With mysteries, a lack of information isn’t the problem. There is no shortage of economic forecasts or investment research. Instead, what’s needed is insight.
In his book The Most Important Thing, Howard Marks describes insight or as he puts it inference.
The essential ingredient here is inference, one of my favourite words. Everyone sees what happens each day, as reported in the media. But how many people make an effort to understand what those everyday events say about the psyches of market participants, the investment climate, and thus what we should do in response?
Simply put, we must strive to understand the implications of what’s going on around us. When others are recklessly confident and buying aggressively, we should be highly cautious; when others are frightened into inaction or panic selling, we should become aggressive.
Is what the present suggests about investing for the future a puzzle or a mystery? If you believe – as I do – that the future is both uncertain and unknowable, then investment is a mystery. Instead of collecting more data or performing more analysis, we need to understand what is happening around us.
Because we’re dealing with the uncertain and the unknowable, our understanding of the future will always be imperfect, incomplete and imprecise. And that’s OK. Any insight we may gain will always be subjective and we may find that we have to change our minds often, as events unfold or new information becomes available.
We can only develop insights about the future by making inferences based on our experience and our skill in understanding what is happening around us. But we don’t have enough time to pay attention to everything. When it comes to insight, not all information is of equal value.
Time is our most important asset and using it wisely is a competitive advantage. In his book Best Practices for Equity Research Analysts, James Valentine, a former director of global training for security analysts at Morgan Stanley, describes two kinds of research analysts.
The defensive analyst attempts to digest all incoming information, regardless of its importance in generating alpha, primarily out of concern that something will be missed. While this is a great CYA strategy, it doesn’t give analysts time to find ideas that separate them from the pack…
The analyst who is on the offensive learns to ignore most, if not all, of the noise, so as to explore unique avenues that may lead to great stock picks. These types of analysts have enough confidence so as not to be embarrassed when they don’t have an answer to more esoteric questions that may come up… Successful analysts spend most of their day on conducting research offensively, specifically focusing on activities that help discover unique insights about critical factors. Some people might call these activities the proprietary aspect of research or the core to developing an edge.”
As investors we can let the fear of what we might miss hold us back from spending our time developing insights. These insights require experienced judgment and the assessment of uncertainty rather than collecting more data.
So what should be our approach to understanding where we are now? For starters, we shouldn’t attempt to solve a mystery as if it were a puzzle.
Part 2 – Tips for dealing with uncertainty
Here are some tips that I’ve found can help investors to “work with” uncertainty.
Investment success is truly about behaving correctly.
Bad behaviour is a serious risk as most of the mistakes made by investors are behavioural. It’s important to always be on the lookout for biased thinking. An excellent way to counteract such thinking is by sticking to a process that’s proven to work over the long-term.
Bad behaviour is also an opportunity. It’s the mistakes of other investors that create the occasions to buy good companies cheaply. These mistakes happen because the decisions of most investors often have little to do with investing and more to do with how they’re feeling.
Insist on a “margin of safety”.
Investing is all about the future, which is challenging because the future is both uncertain and unknowable. Collecting and analysing more information can’t help you to understand what hasn’t happened yet. Relying on history won’t always work. And trying to forecast the future is pointless.The only wise response to these realities is humility.
Investors must accept that they can never control what the outcome of an investment will be. With that being the case, the only rational course of action is to focus on not losing money. This means always investing with a margin of safety. In other words, figuring out what a company is worth and making sure that you pay a lot less.
Think of a range of outcomes rather than a single outcome.
Successful investors well aware of a) the impossibility of trying to predict the future and b) their limits as an investor. That is why they always consider a range of plausible outcomes, some good and some bad, and the factors that might cause these outcomes to occur when selecting investment.
Thinking about a range of outcomes is much safer than basing investment decisions on a single guess of what may happen. It helps an investor to be their own devil’s advocate, forcing them to think carefully about the likelihood of both good and bad things happening to a company. It helps them to come up with a list of events or circumstances to look out for that might lead to these outcomes for a company. It helps investors to develop a list of the things that they need to pay attention to which may cause me to re-evaluate the future prospects of an investment. It also helps them to anticipate the factors that other investors will be paying attention to.
You win some, you lose some.
It’s inevitable that some investments will do well while others will do poorly. It’s why holding a portfolio of diverse investments makes sense as the risk of unexpected losses is minimized by not investing too much in a single company.
Losses are inevitable, but it’s important to keep them in perspective, that is, not to focus on the short-term stock market performance of any one company and ignore the performance of the portfolio as a whole.
Both academic research and practical experience suggest that an investment portfolio can be very profitable even if only 60% of its investments are profitable. Of course, this implies that 40% of all investments may not be profitable.
Profitable investment opportunities always involve a degree of uncertainty and insisting on absolute certainty could mean missing out on a lot of opportunities.Accepting that you can still make money without getting every investment decision right helps investors to keep looking for profitable investment opportunities.
Cash can be the most valuable investment of all.
Most investors consider holding cash to be a drag on investment returns. This is absurd, because it ignores the value of the flexibility that cash provides to an investment portfolio.
Holding cash gives an investor a buffer when times are tough. It means that they are less likely to be a forced seller during periods of market distress. It also means that investors have the ability to take advantage of opportunities to invest at bargain prices.
Cash reduces the risks associated with holding a concentrated portfolio. Finally, cash is the ultimate protection against the unknown.
Only invest in what you can understand.
Investors should aim to find a handful of good businesses that are selling at prices that underestimate their real value. They don’t need to research every company to do this.
If a company’s business is difficult to understand, or if it’s difficult to reasonably estimate the company’s value, they can skip it and move on. Investors can afford to do this because there are thousands of companies listed on the stock exchange.
Discarding a few companies that are hard to understand leaves them with more than enough opportunities for research and investment. Sticking to companies that can an investor can understand also reduces risk.
Valuations are just guesses.
No valuation will ever be accurate. Valuations rely on assumptions and assumptions involve making guesses about the future. But the process of valuation is incredibly important; it forces an investor to ask questions that will deepen their understanding of a company and provide clues about its future prospects.
The importance of time.
Historical evidence suggests that investors can be confident that if they can identify good companies that are selling cheaply, the market will eventually recognise the value of these companies and reward their hard work. Unfortunately, it is impossible to know exactly when that will be. History suggests that it usually takes 3-5 years for the markets opinion about a company to change, but it can be more or less.
Being able to invest patiently is one of the biggest advantages that investors have. The majority of the shares listed on the stock exchange are held by large institutional investors. Instead of promoting a long-term view, the governance and regulation of these institutions create perverse incentives that force them into investing for the short-term.
The advantages to being patient will only increase as these institutions control a bigger share of the stock market.
It’s often easier to work backwards.
Working backwards is usually more objective and saves time. For example, it’s much quicker and easier to identify and exclude bad companies to avoid than it is to identify good companies worthy of investment.
This logic also applies to valuing companies. An investor could value a company by making lots of assumptions (guesses about the future) about company sales, margins, costs and working capital (any or all of which could be wrong) to arrive at an estimate of a company’s fair value.
Instead, it’s better to start with the price of the company’s shares and then ask what values for variables such as company sales, margins, costs and working capital are implied by the market price. An investor can then compare each of the implied variables, with similar companies or with the same company at different times in its history to see if these implied levels are unduly pessimistic, reasonable or overly optimistic.
This is easier to do because variables such as margins, costs and working capital tend to vary less than a company’s share price over time. Importantly, reliance on forecasts – which are unlikely to be correct – is minimized.
If in doubt, stick to the base rate.
Always stick to the base rate, unless there’s a specific reason not to. For example, if an investor was asked to guess the height of the next person walking into the room they might pick a number around 165cms. If an investor was told that the next person to enter the room was male, they would probably increase their estimate, since males are usually taller than females. If an investor was also told that the next person to enter the room was a basketball player, they would further increase their estimate.
In other words, investors should start with what they know to be most probable for a particular company, industry or even the market as a whole and then adjust their expectations, or my base rates, as they learn new information.
History doesn’t repeat and can’t be used to forecast, but understanding history is important because an investor can use it develop a reasonable set of expectations. Understanding the history of a company or industry helps investors to develop a picture of what the base rates are for variables such as sales, margins, costs, etc. and how to adjust these base rates for different market conditions.
Risk and volatility aren’t the same thing.
Volatility is often a poor measure of long-term investment risk. This is because volatility and opportunity often go together. In other words, seeking to avoid volatility will sometimes mean missing some of the very best opportunities to invest.
For example, an investment strategy that seeks to minimize volatility will reduce its exposure to assets that have fallen in price, as a rise in volatility usually accompanies a fall in price. The corollary of this is that assets are less volatile when their price has risen, so seeking to minimise volatility has the potential to bias a portfolio’s towards expensive assets.
Value is a far better measure of risk. The more that an investor pays for an investment, the smaller my buffer against the unexpected is. So the best way for investors to manage risk is by being disciplined about what they’re prepared to pay for an investment and always building a margin of safety into their portfolio.
Risk management is a way of thinking.
Incorporating a margin of safety helps to reduce risk, but more is required. Managing risk also involves thinking deeply about questions such as:
- Do I understand what the risk is?
- What is the likelihood of the risk eventuating?
- What is the impact or the consequences of the risk?
- What can I do to avoid or mitigate the risk?
- What can I do if the risk eventuates?
- Am I being paid enough (i.e. are the expected investment returns large enough) to justify the risk?
- Am I exposed to the same risk elsewhere in the portfolio? If so, should I increase my exposure to this risk?
- What is the consensus opinion regarding the risk? Do I agree or disagree with the consensus and if so why?