However much research and analysis into a particular idea we do, there will always be unknowns we have to consider as investors. Even if you spend hundreds of hours researching a specific business, there will always be a blind spot you have to consider.
Researchers believe that you learn 80% of information about any topic in the first 20% of the time spent on the subject. It takes 80% of your time to discover the last 20% of the information, but even then there's no guarantee you will know and understand everything there is to about the particular topic you are researching.
This is undoubtedly true about businesses as well. There will always be unknown unknowns that only come to the surface in a hostile environment, and this is probably one of the biggest concerns most investors have. How do you prepare against these unknowns and ensure they do not lead to a permanent capital impairment?
Discovering unknowns
There is no definitive or short answer to this question. Even Warren Buffett (Trades, Portfolio) acknowledges that when researching a business, there will always be things he does not know about an entity, and he tries to factor this into his investment research. "We try to think about two things," he told Berkshire Hathaway shareholders at the conglomerate's 1998 annual meeting. "We try to think about things that are important and things that are knowable."
This is valuable if imperfect advice. As the Oracle of Omaha went on to say, in investing and life, there are things that are "important that are not knowable" and "things that are knowable but not important." So, before approaching any investment, Buffett and his right-hand man Charlie Munger (Trades, Portfolio) ask, "What is important and what is knowable?"
The duo don't want to clutter their minds up by trying to research things they are not going to understand, so they concentrate their time and effort on what they do know and understand. This invariably means sticking to specific industries and sectors, but staying with inside their circle of competence is no bad thing. At the same time, the duo try not to overthink about what the future holds and perfectly predict the trajectory of a business.
"So we have our view about what the world will look like over the next ten years. In business or competitive situations, we're just no good," Buffett added. He went on to say that he has some idea where companies like Coca-Cola and Gillette will be in 10 or 20 years, but due to the various unknowable factors, it is difficult to accurately predict where the stock will be. The Oracle of Omaha gave one example, Coca-Cola (KO) when it went public in 1919:
"Coca-Cola went public in, I think, it was 1919. And the first year one share cost $40. The first year it went down a little over 50%. At the end of the year, it was down to $19. There were some problems with bottler contracts. There's problems with sugar. Various kinds of problems.
"If you'd had perfect foresight, you would have seen the world's greatest depression staring you in the face, when the social order even got questioned. You would have seen World War II. You would have seen atomic bombs and hydrogen bombs. You would have seen all kinds of things. And you could always find a reason to postpone why you should buy that share of Coca-Cola.
"But the important thing wasn't to see that.
"The important thing was to see they were going to be selling a billion eight-ounce servings of beverages a day this year. Or some large number. And that the person who could make people happy a billion times a day around the globe ought to make a few bucks off doing it. And so that $40, which went down to $19, I think with dividends reinvested, has to be well over $5 million now. And if you developed a view on these other subjects that in any way forestalled you acting on this more important, specific narrow view about the future of the company."
The bottom line
It might seem counterintuitive to suggest that good investors acknowledge there are always things they will never understand, but this is an excellent approach if you want to avoid making a mistake.
You will never be able to know everything there is to know about the businesses you decide to buy, so why try to answer questions you don't have the answers to? It is better to focus on what you do know, the knowledge there may be something you don't know, and build that into your investment process.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:Â
Warren Buffett on Annual Reports: There's More to It Than the NumbersÂ
Warren Buffett: The Art of Asking Questions to Become a Good InvestorÂ
Warren Buffett: There Will Always Be Opportunities for Value InvestorsÂ
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