THIS ARTICLE WAS WRITTEN BY SUI CHUAN AND FIRST PUBLISHED ON VALUEEDGE
The term ‘known unknowns’ originated from United States Secretary of Defense Donald Rumsfeld during a news briefing regarding weapons of mass destruction in Iraq. I first came across this phrase a couple of years ago and it has had a profound impact on my perception of knowledge and investing.
Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.
We have talked about the 80-20 rule of investing in our earlier post – ‘How much information is enough?’ This relates to the quantity of information; for it is quantity that most people are concerned with.
Investors as a whole tend to be very curious people with a rapacity for knowledge. They want to know everything. And who can blame them really? More often than not, they are expected to know everything about their investments. As a result, most people strive to achieve 100% of known knowns before they make an investment decision. This is almost impossible to achieve, not to mention time consuming and inefficient. So how do we work around this?
This brings us to our next level of framework which basically says – if 80% of the information indicates that a company is cheap, it is most likely cheap.
Forget about the remaining 20%. Under this framework, an investor will have 80% of known knowns and 20% of unknown unknowns in an investment decision. The first point of note is that it is most likely – and not always – cheap. Investors who think otherwise are only deluding themselves. Why is it not always cheap? The most common and simple answer is probability and randomness. Within the 80% of known knowns, things do not always go as expected, shit happens. As an investor, these can’t be avoided; it’s part of the game.
However, I believe there is another source of randomness that can be reduced and it lies within the 20% of unknowns unknowns. This is where Donald Rumsfeld proves to be enlightening. The framework cavalierly regards all unknowns to be unknowns unknowns and the key is to transform them, as far as possible, into known unknowns. The difference is one of mentality and mindset.
Assuming a stock trading at 1x EV/EBITDA and 2x P/E, one will see an undervalued stock and proceed to buy it. Another will ask ‘under what circumstances (which I am currently not aware of) will this not be considered cheap? ‘
It forces an investor into a mental checklist. By being aware of the things one doesn’t know, one effectively evaluates and disregards them as insignificant risks. From time to time, one will invariably find an unknown unknown that should instead be a known known, changing one’s thesis.
Here’s an analogy. You know how some cars beat the lights and proceed to drive though even when the pedestrian crossing signal is green? As a pedestrian, you will never know if the next oncoming car at your crossing is going to be that car (unknown unknowns). An investor who relies on the faith of 20% unknown unknowns is one who sees the green man light up and is willing to walk across the street with his eyes closed. An investor who relies on 20% of known unknown however, walks across the street while still on the lookout for any stray cars, for he is fully aware of that risk.
In the lifetime of these 2 investors, it is unlikely that the former will run over at a pedestrian crossing, but one cannot deny who is at a greater risk. It is for this reason that I believe the most successful investor is neither the one who possesses 100% of known knowns (because he will won’t be able to see many stocks), nor the one who acts on 80% of known knowns and 20% of unknown unknowns, but the one who possesses a cumulative 100% of known knowns and known unknowns.