Most of the pitfalls when trying to adopt the framework stems from the investor’s own behavior and foundational beliefs. Being comfortable with the knowledge about the investor’s limited knowledge is one of those attributes that is paramount when it comes to striving in the business of value investing. It is what Warren Buffett calls being aware of your circle of competence and staying within you comfort zone.
Uncertainties In Investing: Beware of the Unknown Unknowns
Investors in the stock market face two forms of uncertainties (=unknowns). Known uncertainties and unknown uncertainties. To tackle the issues concerning known uncertainties, information gathering is highly useful. Nothing to write home about. The investor knows about his limited knowledge, can ask the right questions and hopefully finds an answer and solution to that question by researching. Known unknowns are risks and problems that most investors can be vigilant about and can prepare by, for example, taking insurance on. Basically, it is a non-issue!
Most problematic in investing, and in life generally, is tackling unknown uncertainties (unknown unknowns). Unknown uncertainties are risks and problems Investors do not even know exist, let alone being vulnerable to. Many will attribute the notion of unknown unknowns with Donald Rumsfeld's remarks concerning the existence of W.M.D in Iraq, and will dismiss the concept immediately. If they knew that the phrase of unknown unknowns originated in the world of design and engineering probably the idea would resonate wide and far. Their pile of too hard to understand investments would grow significantly, which strikes me as a very intelligent behavior.
Unknown uncertainties are problems that haunt the mediocre investor in the stock market without his knowledge. The average investor does not realize the clues and dangers he neglects and hardly ever accepts the concept of limited knowledge. Investors, and humans in general, have the tendency to act and prepare upon the known, might they be known knowns or unknown knowns. But fail to act, and prepare upon, circumstances they have no conception of. Unknown uncertainties are the main reason for everybody’s field of ignorance. And it is the investor's ignorance that profoundly channels the course of action and the final outcome of his investments. Unknown Unknowns are the reason why the majority of people on Wall Street tend to learn nothing and forget about everything.
The Vice of Market Timing
The implications of the concept of limited knowledge are twofold. Firstly, stop forecasting and trying to time the market. The future is just inherently unknowable and thus, forecasting and timing the market tops and bottoms are a waste of time. As Graham wrote: "Most emphasis is laid in Wall Street upon the science, (...), or pastime, of prophesying the immediate action of the general market. However, if we cannot forecast then it would seem incredibly unlikely that we will be able to call the bottom of the general market. As such we should eschew attempts to time the market.“ Furthermore, in an interview Benjamin Graham also noted that: "(...) (the) basic contentions about the efficient market, the thing for people to do is to try to study the behavior of stock prices and try to profit from these interpretations. To me, that is not a very encouraging conclusion because if I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what's going to happen to the stock market. "
The Virtue of Graham and Dodd Investing
Secondly, and more importantly, the concept of unknown uncertainties make the framework to investing outlined by Graham and Dodd even more compelling. Because it is one of the very few where a lot of smarts is not needed. It is a framework were no tensor calculus or quantum physics has to be applied. It is a framework where the Investor does not even need an above average IQ. All he needs in order to survive to the point where he can produce satisfactory long- term results in the field of stock investing is to be a knowledgeable and patient idiot. To follow Graham and Dodd's approach to investing, which requires a wide margin of safety (i.e. a big discount of the stock price to the estimated intrinsic value), is an admission of unknown uncertainties and an acknowledgement of the value investor's limited knowledge and ignorance.
In an interview Benjamin Graham (1976) made clear that: " (...) Imagine- there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up. (...)" He goes on to point to the fact that: "(...) Well, naturally, the thing that I have been talking about so much this afternoon is applying a simple criterion of the value of a security. But what everybody else is trying to do pretty much is pick out the "Xerox" companies, the "3M's", because of their long-term futures or to decide that next year the semiconductor industry would be a good industry. These don't seem to be dependable ways to do it. There are certainly a lot of ways to keep busy. (...)"
Wall Street is crowded with over- confident people whose golden rule is not admitting to their ignorance. Self- reflection and humility is alien to them and I doubt that this will ever change. The investors that accept the concept of limited knowledge will see a number of valuable insights into investing start to flow through their mind. If embraced wholeheartedly those investors will be ahead of the pack on Wall Street and increase the probability of success in the investing business on the long- run significantly.
James Montier; Mind Matters: An admission of ignorance: a humble approach to investing; 27 October 2008
AN HOUR WITH BEN GRAHAM:Interview by Hartman L. Butler, Jr., C.F.A. La Jolla, California March 6, 1976
The Anosognosic’s Dilemma: Something’s Wrong but You’ll Never Know What It Is