What we don't know

During the recently concluded Emerging Markets Finance Conference, organised by Finance Research Group,  Michael Barr presented on the topic 'Finacial Regulation: The Long View'. As a precursor to his talk on the Dodd-Frank Act, Michael presented how financial crises are caused because of things 'we don't know'. It's not as simplistic as it sounds and luckily for us, Michael broke it down.

As an amateur investor who's grappling with so many unknowns, I thought Michael's first slide was very relevant to the investing process. After all, most financial misadventures, at the level of the entire economy or in individual investing, are caused due to human misbehaviour. We can save ourselves a lot of trouble by being intellectually honest and putting unknowns under different types before making any investment decision. Here's the list:

1. What we once knew but have now forgotten - Well, shame on you! As George Santayana famously said, "Those who cannot remember the past are condemned to repeat it." Enough said.
   
   
2. What is knowable but is kept hidden - There's some leeway to get around this. Attend conference calls and ask tough questions. Reach out to investor relations and seek meetings with management (some investors think that they might get biased after such meetings and that concern is warranted). Also one could do some scuttlebutt on their own and speak with customers, suppliers, dealers, etc. in the value chain to know things. Beyond this, if you're still unsure, you should give the idea. When in doubt, tune in later.
   
3. What we know, but don’t know what it means - These fall out of your circle of competence and are best avoided. For example, I know there's an NPA problem in Indian banking presently. So what? Can I take a contrarian call on some banks that are financially healthy? No, because I don't know how to evaluate NPAs, let alone the health of financial firms.
   
   There's scope for improvement here. Try to get to the bottom of things. Increase your circle of competence. If something seems difficult to understand, inverting might be helpful.
   
4. What we don’t know that we don’t know - The Black Swan. Even with the biggest firms (with supposedly high levels of transparency), agency problems will remain and in certain cases, shareholders will be poorer for it. For example, the Satyam scandal. If auditors were duped, there's little chance you'd have been diligent enough to see through the accounting gimmickry. Or the recent Welspun issue. Consider these as black swan events and move on. But learn from these events, so as not to repeat mistakes from type 1. This way you will be cognisant that none of your positions should be large enough (no matter how great your conviction is) to cause you permanent damage.
   
5. What we should do about things we know - Undoubtedly the most hilarious. On one hand, not acting on what we know leads to errors of omission. But on the other, acting inappropriately might lead to errors of commission.
   
   I am firmly in the camp that believes it's best to pass opportunities where one cannot ascertain potential upside/downside AND where the risk reward ratio is not favourable. With this framework, it's probably better to have errors of omission than errors of commission. Errors of commission can be avoided to some extent by putting every investment thesis through a checklist to see which ideas survive and how much you should bet on them. If type 4 types unknowables don't spoil the party, at least some of your investment thesis will stand the test of time. Only a few of these are required to make the biggest positive impact on your portfolio in the long run.

So what can you do?

• Type 1: Eliminate them. History is a great teacher and it's highly likely that the situation at hand resembles something that's happened in the past. Not to you maybe, but maybe to some other great soul. Buffett says - "It's good to learn from your own mistakes. It's better to learn from others' mistakes."
  
  Read financial history, about investing legends and their investment process. You're likely to come across many companies from mature economies such as US and these learnings may be directly applicable to India currently or in the future.
  
• Type 2 & 3: These can be minimised through constant learning and an increasing circle of competence.
• If you are unable to increase your competence because of lack of will/time, pass such opportunities for a future date when you're more inclined to think about them in greater detail.
• If you can't eliminate the 'hidden' aspect of the unknown, be cognisant that it might come to bite you in the ass as a type 4 unknowable. Even if the risk/reward ratio is highly favourable, you're better off not assigning high weight to such a position in your portfolio.

• Type 4: What you cannot avoid, you must live with. Take these in your stride. Don't give very high weights to any position no matter how high your conviction.
  
• Type 5: Stick to the checklist and create feedback loops to your investing process. Be the devil's advocate and ask - what you think you know is really all that is required to know? If the answer is not a resounding yes, there's scope for improvement.

It is my attempt to think about the moving parts of any business and put different components under these different silos. Hopefully, this will make me cognisant of strengths and weaknesses of my knowledge and lead to more sound decisions.