Know What You Need and What You Know

Know What You Need and What You Know

* This is the 3rd article in a series about the Confidence Allocation *

“Ignorance more frequently begets confidence than does knowledge.” – Charles Darwin

When it comes to investing, or anything in life for that matter, knowing what you don’t know is incredibly important.  In a twist of irony, many times our ignorance actually makes us more confident.  In his article, We Are All Confident Idiots, Cornell professor David Dunning had the following to say about this tendency:

“The American author and aphorist William Feather once wrote that being educated means “being able to differentiate between what you know and what you don’t.” As it turns out, this simple ideal is extremely hard to achieve. Although what we know is often perceptible to us, even the broad outlines of what we don’t know are all too often completely invisible. To a great degree, we fail to recognize the frequency and scope of our ignorance.”

When our ignorance is undetectable, it’s hard to avoid.  It’s a tripwire that can sneak up on us; something we have to be cognizant of and try to avoid.  Josh Kaufman, author of The Personal MBA has a different, more optimistic take on the issue:

“Once you learn a bit more about a new subject, you become “consciously incompetent”- you know you don’t know what you’re doing.  As a result, most individuals become less confident in their abilities shortly after learning more about a topic-more knowledge makes it easier to fully appreciate the limits of their knowledge and capabilities.”

The older I get, the more I think I fit into this category.  The more I know, the more I know how little I know.  This humbleness comes from experience.  It’s an understanding I haven’t always had but as time goes on, it has become extremely valuable.

What Do I Know

Ray Dalio, founder of the largest and arguably most successful hedge fund in history credits much of his success to understanding the limitations of his knowledge.

“Our greatest power is that we know that we don’t know and we are open to being wrong and learning.”

So what do I know about investing in markets?  Well, first of all, I know a lot of very smart people work in the investment industry.  I actually don’t know many people in this industry who aren’t extremely bright.  Through research and direct contact, I know these people are very good at what they do.  I am 100% confident that thousands of really smart people trade in financial markets every day and help set prices efficiently.

I also know that at any given time, these really smart people can have really different opinions as to what market prices should be.  I know some of these opinions will turn out to be right, some will be wrong.

And here’s the thing…

Even as a financial advisor, I don’t know what the market is going to do.  I don’t know which smart fund managers will be right, and which will be wrong.  I’m not afraid to admit that.  People who tell you otherwise aren’t being honest.

Having spent years studying markets, I’m confident in the fact that in general, markets do a pretty damn good job at rewarding investors for taking risks.  Furthermore, I’ve found very little evidence that in the long run, anybody can consistently outsmart the collective pricing power of millions of investors.

Evidence Based Investing

Last week, S&P Dow Jones Indices released its latest version of the SPIVA Scorecard.  This analysis is published semiannually and monitors the performance of active fund managers compared to their benchmarks.  In reviewing the publication, the Wall Street Journal points out the following:

Over the 15 years ended in December 2016, 82% of all U.S. funds trailed their respective benchmarks, according to the latest S&P Indices Versus Active funds scorecard. This was the first year that the analysis included 15 years of data, helping smooth out periods of volatility that can affect the performance of active managers.

Among more than a dozen categories tracked, 95.4% of U.S. mid-cap funds, 93.2% of U.S. small-cap funds and 92.2% of U.S. large-cap funds trailed their respective benchmarks, according to the data. 

Yikes!  The evidence clearly suggests that beating the market is extremely difficult…even for really smart fund managers.

After considering this evidence, here are four questions investors should ask themselves:

  1. Am I confident in my ability to choose the 10% of really smart people that can outperform the market?
  2. Am I confident that if I pick the “best” fund managers today, they will continue to be the “best” fund managers tomorrow?
  3. Are the “best” fund managers lucky or skillful?
  4. Should I be concerned with outperforming the market?

I’ll share my answers with you.

  1. No
  2. No
  3. Tough to tell.
  4. No.

Confident Investing

How does all this fit into the confidence allocation?  Allow me to summarize…

  • I’m confident that a lot of really smart people do a really good job at setting prices.
  • I’m confident that the best way for me to earn my fair share from the market, is not by trying to pick the best investments or best managers, but by investing in the collective pricing power of all the really smart people.  The market as a whole.
  • The success of my financial plan has nothing to do with whether or not I outperform stock market benchmarks.  I don’t need to beat the market.

The paradox in all of this is that I shy away from most active managers not because I don’t think they are good at what they do, it’s because I think most of them are very good at what they do.  That’s the paradox of skill at work.  I think passive index investing works better than most active investment strategies because there are a lot of really talented investment managers!  Weird to think about right?

I’ll close with another great insight from Josh Kaufman.  It is the crux of what I call the invisible alpha

“Focus more of your energy on things that you can influence, and let everything else go.  keep your attention on what you’re doing to build the life you want to live and it’s only a matter of time before you get there.”

Further Reading…

This is post is the third in a series about confidently allocating your portfolio…

Part 1 – Allocating Confidence

Part 2 – The Future is Bright

The Invisible Alpha

Tim Brennan

Comments are closed.