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Learn your knowns and unknowns

When investing capital, you expect the return to adequately compensate you for the likelihood of loss. Understanding both risk and reward is vital, so the more you know about ‘knowns’ and ‘unknowns’ the better.



Investing is a ‘risky’ business. Whenever you part with capital, you’re doing so in the hope that the return will adequately compensate you for the likelihood of loss. As such, one of the keys to long run success with any investment is an intimate understanding of both risk and reward.

Unfortunately, it seems that people are more familiar with the expected returns of an investment, and less aware of the risks required to generate those returns. This is akin to investing with a blindfold on. For instance, many investors will be familiar with a company’s dividend yield as distributions are a primary source of their income. But they may fail to consider that their income can be adversely affected by a drop in the share price if they sell.

Assessing different possible outcomes

This imbalance may be explained by the inherent difficulty of quantifying risk in the share market. To accurately assess risk, you need to understand the payoffs from all possible outcomes. For instance, when you enter a casino and walk up to a roulette table, there are three possible outcomes from putting your chips on black. If the ball lands on red or zero, then you lose all your capital. If the ball lands on black, then the payout is twice the initial wager.

Defining the risks and rewards in the share market is far more intensive. It’s vital to understand intimate details of a company’s operations and all external forces that may impact earnings.

Of course, there are natural constraints to the amount of time, effort and resources one can commit to research. What’s more, if you attempt to understand every minor aspect of a company, you may become lost in the detail and fail to see the bigger picture.

Clearly there will be a point where you will have a sufficient, but incomplete amount of knowledge to justify your commitment to an investment. But how long should you spend researching a company?

Unfortunately, there is no clear answer this question. What may be helpful though is to consider Donald Rumsfeld’s simple (yet rather ineloquent) approach to assessing risk. The former US Secretary of State divides risk into three categories – known knowns (things that we know that we know), known unknowns (things that we know that we do not know), and unknown unknowns (things that we don’t know we don’t know).

You may need to re-read that passage again before continuing. Although it’s a complete tongue-twister, we can actually apply this into a research framework.

What we know and what we don’t know

The easiest place to begin researching a business is to consider the known knowns. What do we know about long-term performance? Has the business been successful in the past, or is it just another promising story?

A deep pool of academic research has shown that companies that have generated meaningful returns over a long period have certain financial characteristics. For instance, companies with a track record of high returns on equity and strong balance sheets should offer more compelling long-term value than companies with highly volatile performance and excessive borrowings.

Understanding a company’s financial statements will help shape your subsequent research, as it will allow you to become aware of certain unknowns that warrant investigation.

A critical known unknown is how the business operates, yet many investors would dismiss this as a known known. For instance, you may think you know how Woolworths operates, because you buy your groceries there. But can you clearly articulate how one dollar of revenue flows through the business? The more you understand how a business operates, the more unknowns you will become aware of, which further improves your understanding of the investment’s risk.

Your analysis should continue until you’re comfortable for the known unknowns to remain unknown. For instance, the customer base of a business is a critical known unknown. If your research reveals that a company is dependent on a single customer, this presents a material unknown that requires further investigation. But if the customer base is highly fragmented, then it may not be worthwhile (or even possible) to identify the risks in every contract.

Invariably there will always be unknown unknowns when investing. The weather, global events, human behaviour and emotions can have a meaningful impact on a company’s prospects, but these are more difficult to quantify.

It is because of this unquantifiable risk that we should require a sufficient margin of safety to warrant the investment. If we remain patient and wait for the share price to trade at a meaningful discount to what we think the business is worth, then this gives us an additional buffer against adverse events that we’ve yet to consider.

Of course, your analysis of a company won’t stop once capital is committed. Over time, you will become aware of more unknowns, and these revelations may result in a completely different investment thesis. While your investment style may become more conservative with this approach, your portfolio is more likely to generate returns that better reflect the effort applied to understanding the risks.

 

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able

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