The Three Levels of Conviction

The Three Levels of Conviction

By Jack Forehand, CFA, CFP® (@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.

We were very lucky to interview Jim O’Shaughnessy in the early days of our podcast and what struck me more than anything else in that discussion was his willingness to admit the things he didn’t know. All of us want to seem competent. We want to seem intelligent. Admitting that you don’t have an answer seems like it is in direct opposition to those goals. But maybe the better goal instead of seeming competent is to actually get more competent, and without admitting your deficiencies, that will never happen.

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 ——— Thinks 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. What it has also done is made me realize how few things actually fit into the “Things I Know” bucket since it is very difficult to know anything with 100% certainty.

To illustrate this approach, I wanted to list some of the things that fit into each category for me right now.

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 the market will be higher 20 years from now.

Your first reaction to this one is probably to think that it belongs in the “Things I Know” pile. After all, there has never been a 20-year period where the S&P 500 has produced a negative return. But as many people often say on Twitter, now do Japan. And Japanese investors who invested in 1989 are still under water today over 30 years later. Is that likely to happen in the US? Probably not. But is it possible? Absolutely.

I think value investing will continue to work over the long-term

Value has certainly come under fire in recent years, which makes sense given its long run of underperformance in the decade prior to 2020. But long periods of underperformance have been par for the course historically for value, so there is nothing new there. When I look at the behavioral and risk-based explanations for why value works, I see nothing in that period of struggle that would refute them. So I continue to believe in its long-term future. But having said that, there are some value investors who talk about the fact that value will work as if it is a certainty. And I don’t think that is an intellectually honest position. There are also certainly versions of the world in the future where value will not work. Investing is a game of probabilities. I think the probabilities support value in the future, but I also recognize that the probability of its future outperformance is not 100%.

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, and they have been emboldened by the recent declines. There are also very intelligent people who think crypto will change the world. 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 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

The recognition that what I don’t know will always exceed what I do has made me a better investor. 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.

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at 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.