By Jack Forehand (@practicalquant) —
There are some areas of life where you can never have all the answers – no matter how much you know, how smart you are, or how good the school was you got from your degree from. Investing is one of those areas. As humans, we want to believe we can know everything. We want to believe if we work harder or read more, we can finally get to a place of having all the answers. That belief, when coupled with unpredictable things where no absolute answer exists, can lead to very dangerous consequences.
I was listening to an excellent podcast Ted Seides did with Anthony Scaramucci (click here to listen) the other day and it got me thinking about this. They were talking about the lessons he has learned in life and he said something very interesting that I think gets at the key to investing success better than anything I have heard.
“It’s not the stuff that you do not know that’s going to hurt you in the world of investing … it’s the stuff that you think you know with absolute clarity and absolute axiomatic fact … that is going to hurt you” — Anthony Scaramucci, on the Ted Seides Capital Allocators podcast
What he is saying here is that for many investors, what you think you know is much more dangerous than what you don’t know. That may sound counterintuitive because many people believe that knowledge is the key and that the more you add to your knowledge, the better you are. And I can’t argue with that. But with knowledge often comes more conviction that you have all the answers. That can lead to overconfidence and poor decisions.
I have certainly not been immune to this myself. As I have learned more about investing, I have made decisions with more confidence. But at times that confidence wasn’t warranted by the facts. And it can be compounded by the fact that, like many people, I have tended to follow those who agree with me, which just serves to reinforce my existing beliefs.
Find Diversity of Ideas
To combat this, I have made a concerted effort to follow more people who don’t agree with me. Getting perspectives that are contrary to what I think has been really helpful. In addition to that, I have tried to take any belief I have about investing and to put it into one of three buckets before I take any action as a result of it.
The Three Buckets of “I Know”
Things I Think
|Things I Know||
Things I Don’t Know
Classifying things in this way has allowed me to better judge my level of conviction and to question myself more regularly, which is key to investing success.
To illustrate this approach, I wanted to list some of the things that fit into each category for me.
I know that investing earlier and investing more are keys to achieving your long-term goals
There are certain rules that are indisputable. One is that the more you invest in the present, the more you will have in the future. The other is that compounding is the most powerful force in investing and the longer you can take advantage of its benefits, the better you will do. This means investing as early as possible to make your time frame as long as possible.
I know that if two investments are the same or similar, the one with lower fees will win.
In aggregate, there is probably nothing that is more predictive of future results than fees. Yet there are still many funds out there that are either the same as or very similar to the market, but charge much higher fees. Investors in those funds are paying extra for something that is almost guaranteed to offer no value. This doesn’t mean fees high fees are always bad. There are certainly some focused, high active share products out there that are very different than the indexes and have the opportunity to justify their fees. But they are rare relative to the closet indexing products that are just providing the same return as the market before fees, and a worse return after them.
I think that investing using factors will continue to produce better returns than market cap weighted indexes going forward. I don’t know whether the factors that work best will be the same ones that did so historically.
Data over very long periods of time supports that using factors beats market cap weighted indexes. But the factors that work best change and it is very difficult to see those changes coming before they happen. For example, in retrospect it is easy to see the flaws in Price/Book that are likely part of its terrible performance in the past decade. But very few people saw that coming a decade ago. The same is true for the small-cap premium, which many now believe is either smaller than previously thought or doesn’t exist at all. It is very possible that some of metrics that everyone loves today will suffer a similar fate.
I know that even if factors do continue to work, emotions and biases will prevent most investors from using them successfully.
No level of technological innovation can change the way we are wired. We want immediate results. When we don’t get them, we make bad decisions. Those bad decisions hurt our investment performance more than any other factor. Even though factor investing works, most people shouldn’t do it. We just aren’t equipped to sit through periods of underperformance that can span over a decade. And as this great article explains better than I can, these periods may be getting even longer in the future.
I think value stocks will rebound at some point. I don’t know when that will be. I think they will continue to outperform the market long-term.
I am a big believer in value stocks. The data supporting their long-term outperformance is compelling. When they have gone through periods like they are going through now historically, they have always come back, and the reversion has typically been very strong. The more you study the issue, though, the more you realize that there is no length of underperformance that allows you to predictably determine the timing of the turnaround. An honest look at it also leads to the conclusion that value outperforming over the long-term in the future is not a certainty. If anything is certain, then there isn’t risk, and without risk, you don’t get return. As a result, I classify this in the “I strongly think” category, but it doesn’t belong in “I know.”
I don’t know whether cryptocurrencies will be a good long-term investment
Perhaps no issue generates more anger on both sides than the future of cryptocurrencies. There are very intelligent people who think they will all end up worthless. There are also very intelligent people who think they have only realized a small fraction of the value they eventually will. Whenever I see a situation like that where there are smarter people than me on both sides, I immediately put it into the I don’t know basket. Even if I could come to a conclusion one way or another, history tells us that it will be very difficult to identify the winners and losers in advance so the implementation side of it is very tough. I will continue to spend a lot of time learning about this, which is what I try to do with things in my I don’t know bucket, but I recognize this is an area I am not qualified to have an opinion on.
Building A Framework for Success
None of this is meant to pretend that I have all the answers. I don’t and never will. The recognition that what I don’t know will always exceed what I do has made me a better investor. I think the lesson here is that all of us can benefit from being honest about our limitations. For me, grouping things I think I know about investing into these three categories has been helpful in facilitating that honesty and preventing mistakes. When I think I know something for sure, it has challenged me to think long and hard about if I actually do. When I don’t know about something, it has challenged me to spend the time to research it and expand my knowledge. I think many investors might benefit from a similar approach.
Photo: Copyright: ismagilov / 123RF Stock Photo
Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at Validea.com and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.