A bull market can cause investors to become overly confident. For example, some investors may believe they are now more accomplished at allocating capital because they have made large profits in the S&P 500's 50% rise over the past year.
However, in my opinion, it is crucial for all investors to remain honest about the extent of their ability. One way of achieving this aim could be to base investment decisions on what an investor knows, while accepting there are things they do not know.
Li Lu's honest approach to investing
Li Lu (Trades, Portfolio) is an investor who has always sought to take an honest approach to apportioning capital. As the founder of Himalaya Capital Management has previously stated:
"Investing is about intellectual honesty. You want to know what you know. You want to know, mostly, what you don't know."
Li's words could be highly relevant in today's stock market environment. The current bull market has not changed the limits of what investors can know about a specific stock, sector or the wider stock market. However, many investors may now believe that know significantly more than they did a short while ago. This could lead to them taking greater risks than would normally be the case.
Accepting what you do not know
Of course, different investors will have varying levels of knowledge about a company or industry. However, there are some things that no investor can possibly know for certain.
For example, it is impossible to know how a company will perform in future. There are an infinite number of variables that can positively or negatively impact on a firm's future profitability. Estimating all of them and how they interact with each other is not an achievable aim for any investor.
Similarly, investors cannot know how an industry or the wider economy will perform in future. Nor can they accurately estimate how key factors such as the Covid-19 pandemic, political decisions regarding tariffs on international trade or investor sentiment will develop in future.
Accepting this lack of ability may be more difficult after experiencing recent investment success from the stock market's gain. However, it is imperative for investors to remain honest about the limitations of their ability.
Focusing on what you know
Instead of basing investment decisions on areas an investor cannot accurately judge, it may be a better idea to focus on facts and figures. Indeed, it is possible to make an informed decision about the risk/reward opportunity offered by a specific stock or industry through relying on company fundamentals.
For example, an investor can ascertain the financial strength of a business by analyzing figures such as its net debt levels and interest cover. Likewise, an investor may be able to understand the extent of a firm's competitive advantage by assessing its recent results and analyzing the performance of its sector rivals.
Using company fundamentals to apportion capital may not feel instinctive after the recent stock market surge. However, doing so can help investors to avoid becoming caught up in rising market sentiment that causes them to invest in unattractive opportunities.
The stock market's past performance shows that there are limitations to what any investor can know and achieve. Being honest and accepting that fact could be a key step in allocating capital efficiently in the current bull market.
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Why Warren Buffett's Views From the Tech Bubble Are Useful Today
- Seth Klarman: Industry Knowledge Can Provide an Investing Edge
- Mohnish Pabrai: Patience Is Your Most Valuable Asset
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