You Don't Know What You Don't Know

Ignorance Comes with Age

Several months ago, I was at the gym going about my workout as usual. There was a group of older gentlemen, likely in their mid 70s, nearby who were chatting with each other and I happened to be within earshot. I didn't hear the context of their conversation but I did happen to overhear a small part of it that really stood out to me. One of the men told a story about when he was in his early teens (which highlighted the foolishness of youth). At the end he proceeded to say "Yep, I knew a lot more back then than I do now!" and the entire group started laughing. This brief conversation has really stuck with me and pertains to the title of this post: You don't know what you don't know. When we're kids and have minimal life experience we tend to think we know everything. But as time goes on and we continue to explore the world, it becomes increasingly apparent that we know very little. Mature adults tend to acknowledge how little they know, more so than those that are younger than them. For every skill or concept you master you become aware of 2-3 you know nothing about. The reality is, the more you know the more you realize you don't know.

This is especially relevant given today's context, in a short time frame what most Americans originally thought was an insignificant, flu-like virus only affecting especially unsanitary parts of the world has managed to completely derail the world's major economies and cause a severe dip in asset valuations. There are those in the medical community that say this was predictable but they're people whose career & education pertain to the specific esoteric niche of medicine known as virology. The average investor (or even the above average investor) had absolutely no clue that this was coming YET many people who were trying to predict the future several months ago are still doing so!

The Advice of the Clairvoyant

Earlier this year the US economy was cruising along on one of the longest bull runs in its history. There were TV pundits and online experts of all kinds predicting when and how the market would eventually crash. You'd frequently here the old "we're 12-18 months from a recession" which is conveniently vague. Anyone with even a surface-level knowledge of investing knew that the market would have to crash eventually but nobody knew the specifics. Yet, there were still those who spoke as if they did know how and when it would crash. Then the virus blindsided the world and shutdown the economy in the blink of an eye. Those who were busy talking as if they knew the future were shown to be nothing more than speculators while those who have significant experience were unsurprised by an unexpected catalyst (black swan) causing a recession because they understand that there's much that they don't know, that events can happen that are completely outside their frame of reference and that the future holds a wide range of possibilities.

The Future is a Bell Curve of Possibilities

Science has repeatedly demonstrated that humans are responsible for all kinds of cognitive fallacies and biases such as resulting, hindsight bias, etc (For more on this read Daniel Kahenman's Thinking Fast and Slow). These fallacies allow us to fit what happens in life into our limited frame of reference so that we feel as if the world is predictable/controllable when in fact it is not. We rationalize the past to make us feel more comfortable and in control of our lives. This is problematic as it hinders us from learning from our experiences and causes us to be far too confident in our assumptions about the future. We'd be much better off admitting ignorance and realizing that there is much we do not know about the world. Understanding that many of our successes came from good luck in spite of our bad decisions and that many failures came from bad luck in spite of good decisions. Realizing that the future is ultimately unknowable, is the first step in preparing for that reality.

Have we Learned Nothing?

We're in late May and many states are beginning to re-open their economies. The virus seems to be slowing down and there's potential for the economy to shoot up in the classic "V" shape as many people are predicting. But the reality is, the future is still completely unknown. The economy could come right back or perhaps the damage may already be done, with many businesses not able to re-open their doors we could end up in a deep recession. Or, even worse, it could turn out to be a mistake to re-open the economy and we may end up seeing another huge spike in sickness.

Despite these facts, there are STILL people talking about the future as if they know what it holds. This is completely irrational but unsurprising as the reality is that most people would rather delude themselves into thinking they know the future than admit that it's unpredictable. I've seen predictions ranging from an immediate return to economic prosperity to a global depression lasting for years. The "experts" who make these claims (on both ends of the spectrum) speak as confidently about the future as if they were recalling the past. These soothsayers are all over (ostensibly) reputable platforms and there are many people who will take their guesses about the future as facts. This is unfortunate because we're dealing with completely unprecedented times. Nobody knows how the virus will end up playing out, how many businesses will close their doors permanently or what The Fed's massive influx of capital will do to our economic/monetary system. Any assertions about the future are little more than guesses and the only thing we really know for sure is that the future is uncertain.

The Prudent Investor

With so many different opinions about the future out there, what should the prudent investor do in a time like this? First, they should acknowledge that they don't know what they don't know. Everyone has their own biases and frame of reference when considering potential future outcomes but those that realize their perspectives are limited can hedge against results that are completely unexpected. Second, they should continue capitalizing their portfolio conservatively, avoiding over leveraging and buying at a discount. The entire thesis of this post is that the future is uncertain, thankfully investors who have a clue realize that managing uncertainty and the corresponding risk is what investing is all about. The current situation may pose an especially significant amount of uncertainty (or perhaps just make us aware of it) but conceptually it's business as usual.

We'll use one prediction I've seen as a thought experiment to think through the risk of trying to predict the future in an unpredictable world. On one of the most well known real estate investing forums there was a popular discussion titled something along the lines of "You have 6 months to liquidate your portfolio". The author of the post describes how he believes the housing market will fall off a cliff in 6-12 months, similar to 2008. Ignoring the obvious flaws in this line of thinking (2007/08 was predicated on a breakdown of finance within the real estate world, the average homeowner has far more equity than in 2007/08 and there's an unprecedented shortage in housing), would betting on this outcome ever make sense when you consider the potential risks/rewards? If the author of this post is correct and we experience a recession similar to the Great Financial Crisis (and you hold your properties) what happens? Well, investors will see a massive reduction in the value of their assets, rents may decrease and those who have not been conservative in structuring their business will likely lose their properties. However, for the prudent investor who has the appropriate capital/equity reserves and takes a long-term outlook things will continue as usual. Additionally, if this really does mirror the GFC then they can expect a huge rebound in property values/rents which will quickly surpass previous levels.

What about the flip side? If you act as if you know for certain that housing prices will soon tank and you're wrong, what happens then? Let's say the economy does rebound in a V shape as many are predicting. If you've sold off your assets then you will likely miss out on significant appreciation and rent increases. Even if the economy rebounds slowly over the next several years you're likely to miss out on substantial returns. When you look at the risk/reward of the original assertion that you need to "liquidate you portfolio in 6 months" it just doesn't make sense to take that kind of action based on a guess. But that's the issue, the author of the post (and others trying to predict the future) don't know what they don't know and don't think they're guessing. These people genuinely think that they know the future. If you conduct a similar thought experiment regarding the other common predictions you will reach similar conclusions. The idea is, taking drastic action based on predictions (guesses) about the unknown future is a great way to have a very brief investing career.

So as we wade into a future of unknowns, let us stick to the basics tenets of investing that have stood the test of time. Avoid over leveraging, always keep cash reserves on hand and buy at a discount. That's it. Realize that you don't know what you don't know and avoid the fortune tellers who pretend they do. I'll wrap up with a quote from the late economist John Kenneth Galbraith, "There are two kinds of forecasters: those who don't know, and those who don't know they don't know". Which one are you?