Knowing where we stand and knowing what we don’t know
Previously, we discussed Marks’ thoughts on finding bargains and patient opportunism, contrarianism and psychological pitfalls in investing, market cycles, risk and attitudes to risk, and price and the relationship of price to value.
In the next two chapters, Marks’ discusses the value of knowing what you don’t know in markets, and having a sense of where we stand in terms of market behavior.
The Most Important Thing is ……….Knowing What you don’t Know
Awareness of the limited extent of our foreknowledge is an essential component of my approach to investing.
I’m firmly convinced that (a) it’s hard to know what the macro future holds and (b) few people possess superior knowledge of these matters that can regularly be turned into an investing advantage.
On the other hand, the more we concentrate on smaller-picture things, the more it’s possible to gain a knowledge advantage.
The important thing in forecasting isn’t getting it right once. The important thing is getting it right consistently. If you’re always an outlier, you’re likely to eventually be applauded for an extremely unconventional forecast that correctly foresaw what no one else did. But that doesn’t mean your forecasts are regularly of any value.
While we may know what will happen much of the time, when things are “normal”, we can’t know much about what will happen at those moments when knowing would make the biggest difference.
Most of the time, people predict a future that is a lot like the recent past. • They’re not necessarily wrong: most of the time the future largely is a rerun of the recent past. • On the basis of these two points, it’s possible to conclude that forecasts will prove accurate much of the time: They’ll usually extrapolate recent experience and be right.
Just as forecasters usually assume a future that’s a lot like the past, so do markets, which usually price in a continuation of recent history.
Once in a while, however, the future turns out to be very different from the past. • It’s at these times that accurate forecasts would be of great value. • It’s also at these times that forecasts are least likely to be correct. • Some forecasters may turn out to be correct at these pivotal moments, suggesting that it’s possible to correctly forecast key events, but it’s unlikely to be the same people consistently. • The sum of this discussion suggests that, on balance, forecasts are of very little value.
The key question isn’t “are forecasters sometimes right?” but rather “are forecasts as a whole—or any one person’s forecasts—consistently actionable and valuable?” No one should bet much on the answer being affirmative.
Most of the investors I’ve met over the years have belonged to the “I know” school. It’s easy to identify them. • They think knowledge of the future direction of economies, interest rates, markets and widely followed mainstream stocks is essential for investment success. • They’re confident it can be achieved. • They know they can do it. • They’re aware that lots of other people are trying to do it too, but they figure either (a) everyone can be successful at the same time, or (b) only a few can be, but they’re among them.
They’re comfortable investing based on their opinions regarding the future. • They’re also glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis. • They rarely look back to rigorously assess their record as forecasters.
Marks believes you can’t know the future; you don’t have to know the future; and the proper goal is to do the best possible job of investing in the absence of that knowledge.
No one likes having to invest for the future under the assumption that the future is largely unknowable. On the other hand, if it is, we’d better face up to it and find other ways to cope than through forecasts.
The biggest problems tend to arise when investors forget about the difference between probability and outcome—that is, when they forget about the limits on foreknowledge. Some of the biggest losses occur when overconfidence regarding predictive ability causes investors to underestimate the range of possibilities, the difficulty of predicting which one will materialize, and the consequences of a surprise.
The question of whether trying to predict the future will or will not work isn’t a matter of idle curiosity or academic musing. It has—or should have—significant ramifications for investor behavior. One key question investors have to answer is whether they view the future as knowable or unknowable. those who feel they don’t know what the future holds will act quite differently: diversifying, hedging, levering less (or not at all), emphasizing value today over growth tomorrow, staying high in the capital structure, and generally girding for a variety of possible outcomes.
Investing in an unknowable future as an agnostic is a daunting prospect, but if foreknowledge is elusive, investing as if you know what’s coming is close to nuts. Acknowledging the boundaries of what you can know—and working within those limits rather than venturing beyond—can give you a great advantage.
The Most Important Thing is…….Having a sense of where we stand
Market cycles are unpredictable, in terms of their extent, as well as their timing. The only thing we can predict about cycles is their inevitability.
Why not simply try to figure out where we stand in terms of each cycle and what that implies for our actions?
We cannot know how far a trend will go, when it will turn, what will make it turn or how far things will then go in the opposite direction. However, every trend will stop sooner or later. We may never know where we’re going, but we’d better have a good idea where we are.
Try to (a) stay alert for occasions when a market has reached an extreme, (b) adjust our behavior in response and, (c) most important, refuse to fall into line with the herd behavior that renders so many investors dead wrong at tops and bottoms.
When I say that our present position (unlike the future) is knowable, I don’t mean to imply that that that understanding comes automatically. Like most things about investing, it takes work. Those who are unaware of what’s going on around them are destined to be buffeted by it. As difficult as it is know the future, it’s really not that hard to understand the present. If we are alert and perceptive, we can gauge the behavior of those around us and from that judge what we should do.
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.
We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future.