10 >   Trust Homework, Not Hunches

In the second half of 2014, oil prices made a gradual and remarkable decline from about $105 a barrel to about $45 a barrel. The price of stock in Exxon Mobil, the world’s largest oil company, declined steadily with the price of oil. I found it hard to resist that quality company on sale for a bargain price. I felt the price of oil had fallen too far. I admired the company as a sound business. I figured I wouldn’t mind owning Exxon Mobil stock long term. I bought a bunch.

Over the next few weeks, the price of oil rose modestly, but my Exxon Mobil stock fell. That left me scratching my head. As I watched the price of oil, the price of stocks overall, and the price of Exxon Mobil stock interact, I began to understand better how multiple factors drive profits at that company. Price movements showed me that the value of Exxon Mobil didn’t have a simple relationship to the price of oil. It also responded to interest rates, the value of the U.S. dollar, and especially economic expectations. I also learned more about the supply, demand, and cartel dynamics affecting the price of oil. I realized my knowledge of the oil business and the oil markets was way too shallow to make a call about oil company stock. I’d underestimated the long-term impact of factors driving oil prices down, and I’d made a mistake. I said “uncle” and sold my Exxon Mobil stock at a loss.

As investors, our job is to decide how to use our resources to produce the future results we want. My decision to allocate money to Exxon Mobile stock didn’t lead to the future result I wanted. The investment was a mistake—not because I took a loss, but because I violated one of my own investment rules. I invested in something I didn’t thoroughly understand.

I always think of Ed when I remember what it means to thoroughly understand something. Ed and I lived on the same dorm floor in college. He was obsessed with aviation. He approached every conversation with energy and enthusiasm, but when the subject was aviation-related, his energy went up another notch. The guy was passionate and knowledgeable.

One day my girlfriend and I took the Chicago “L” train out to O’Hare Airport, just to walk around. It was pre 9/11, when non-ticketed-passengers could still go through security. As we looked through the concourse windows, I noticed a jet with an unusual angled engine configuration. I hadn’t seen that before, and I was curious about it.

A day or two later I ran into Ed in the dorm hallway, and asked him. “Hey, Ed. I saw this weird jet engine at the airport the other day. I don’t know what type of plane it was, but it was angled like this. Do you know why?”

His reply blew me away. “It depends if the aircraft was made before or after May of such-and-such year.” He went on to explain the history of that engine and its manufacturer, the basis for the design, which aircraft manufacturers used it during what time periods, and why. I had figured he’d know something about it, but this was over the top. I had asked him a random aviation question with no warning, and he was ready with deep and detailed knowledge about it. Something about that level of mastery thrills me, and it reminds of the difference between knowing a few facts or simple storylines and thoroughly understanding something.

The closer you are to Ed’s level of understanding of what you are investing in, the better. When you thoroughly understand an industry, a company, a technology, a culture, or anything else, you have an investment advantage.

I got another reminder of this a few days before I wrote this section. I was at a social gathering with some of my wife’s friends. Bill, a quiet, middle-aged man, was among the group. At one point in the conversation he told us a little about his day. Bill is an expert commercial roofing analyst. When an insurance company needs to know why a multi-million-dollar roof failed, or a building owner has a leak nobody can figure out, they call Bill. He’s spent most of his life on top of buildings looking at roofs.

That day he visited a large church building with a pattern of leaks popping up in multiple places. He looked at the stains on the ceiling tiles in various rooms of the building, and then told the owner, “I’d say your roof membrane is from [manufacturer X], made between 1987 and 1991, and you had a significant hailstorm last summer.” He hadn’t even climbed a ladder and gone on the roof yet! His diagnosis was correct. Like the Sherlock Holmes of roofing, clues that wouldn’t mean much to others were all Bill needed to solve the case.

Ed thoroughly understands how airplanes work, and Bill thoroughly understands how roofs work. When you thoroughly understand how your investments work, you have an investment advantage.

Don’t Buy Simple Stories

The human brain is a meaning-making machine. We take bunches of facts and details, and condense them into concise interpretations. These stories help us simplify complex reality and give mentally manageable meaning to jumbles of information. We think and communicate with storylines.

For example, when financial markets move this way and that, we look for headlines to give meaning to the data. “Treasuries fell, the dollar fell, and stocks rose because the Federal Reserve said they might wait to raise interest rates.” Ahh. It all makes sense. The perplexed feeling we had when we saw the day’s price charts changes to a pleasant feeling of knowing comprehension.

The trouble is, the reality of what happened that day is much more complex. Millions of investors made buy and sell decisions for millions of individual reasons. The headline’s explanation of the overall result may not even be accurate, but with the story to tame the data, we feel satisfied. Often we feel satisfied by that plausible storyline even though it completely misses the true causes of that day’s price movements.

This ability to simplify observations into stories is a wonderful capability of our brains. It’s necessary so we can cope with the complexity of a world filled with virtually infinite events and information. In many cases, our stories serve us well, because they are good enough models of complex reality.

We might use a simple story like “Traffic is bad so it’s going to take longer to drive downtown.” That’s mentally manageable in a way that analyzing the number of cars on every feeder street is not. The reality of the traffic situation is massively complex. The number of people going to work today, rain or snow on each stretch of road, carpooling trends, accidents, even things like Daylight Savings Time affect the specific details of traffic on a given day. That complexity is simply too much to process, and we don’t need to analyze that complexity to decide what time to leave for our theater date. We simplify, and the mental streamlining we receive in exchange for lower precision is worth it. We can round our drive time up a bit, and make the complexities irrelevant to the decision.

Other stories don’t serve our decisions well. “Lawyers make a lot of money. I want to make a lot of money. I want to be a lawyer.” That’s a simple, mentally streamlined story, and there’s truth in it. At the same time, the complexities masked by this simple story are also highly relevant to the career-choice decision. Lawyers also spend a lot of money on law school. Some lawyers discover they don’t enjoy being lawyers. Some lawyers put in a lot of time as low-paid junior associates before ever making a lot of money. Current trends in the legal profession are toward excess supply, less demand, more automation, and contract outsourcing, putting downward pressure on lawyer’s compensation. There’s a real chance the aspiring student who sets off to make a lot of money as a lawyer, never actually will. The simple story that our meaning-making brains stamp with “makes sense” is an inadequate basis for the decision.

Lots of people recognize that a career choice is a complex, multi-factor decision, and wouldn’t make such a big time investment decision based on a simple storyline. We are familiar enough with the complexities of a career choice to resist drastic oversimplification. We can protest: “But wait, it’s not that simple. What about this factor?”

Perhaps we are more susceptible to trusting simple stories when it comes to financial investments in unfamiliar territory. A classic approach to picking stocks started by dividing them into industry segments, picking the strongest industry at the time, then picking the strongest company in that industry to invest in. It’s a logical story that makes sense, but it didn’t work. The selected companies didn’t perform any better than a randomly selected stock would have. The real factors that drive company profits and stock prices are just too complex to accurately simplify into “strongest industry” and “strongest company.”

“Traffic is bad” is good enough to decide what time to leave for the theater, but simple stories like “more of our electricity will come from wind and solar” aren’t good enough to decide how to invest your money in energy stocks. There are many other factors that influence the future prospects of energy companies, and predicting one trend (not easy in itself) is woefully inadequate to predict investment performance.

Without in-depth knowledge to check them against, simple stories feel plausible and mentally satisfying, even when they are completely wrong. If you find yourself thinking, “I don’t know a lot about this, but that explanation makes sense to me” or “This investment will do well because of one simple factor,” red flag that thought. That kind of rationale is not a reliable basis for investment decisions of any kind, whether relational, financial, vocational, or otherwise.

Thorough understanding, like Ed’s knowledge of aviation or Bill’s knowledge of roofing, is great insurance against buying simple stories. With that depth of understanding, it’s easy to remember that reality is much more complex than a simple storyline. An expert knows what other questions need to be asked and answered to make the right decision.

Invest in Thorough Understanding

You can develop thorough understanding by investing time to research, learn, test, and practice.

Dig in to learn more. Read articles, books, executive bios, Wikipedia pages, or whatever learning material applies. You’ll start to find additional simple storylines that don’t agree with the first one you heard. And you’ll find additional facets of the situation that are relevant.

Don’t be afraid to get practice in an area you are unfamiliar with, for the purpose of learning. Just keep clear that the outcome you are looking for is learning, and the resources you are devoting are a learning cost. Get the learning for the lowest cost that will get the answers you need.

Look for ways to check the storyline in a test or experiment. There’s nothing like real-world results to shatter assumptions and raise interesting new questions.

For example, if you want to learn about trading stock options, practicing by watching actual options respond to price movements is quite instructional. There’s no need to wade in with real money, let alone large amounts of real money, to get that instruction. Recognize your limited experience is a disadvantage, and practice trading with a Website that offers “paper money” simulated trading. You don’t need to risk real money to get the learning outcome you want.

You might learn, as I did, that options trading is harder than it looks. That lesson is less painful when your losses are in imaginary dollars instead of the real thing. If consistent results over time prove you have a real advantage, then risk resources in search of a financial return.

Many storylines can be illuminated through tests or experiments. If the simple story is “Consumers will love this because it has a modern design,” do some test sale on eBay, or read customer reviews to see how consumers actually respond to similar products. If the story is “This company earns more during construction booms,” pull some historical financial statements on that company and test your theory against the data. If the story is “This job candidate will be a great fit because his last job required the same skills,” set up a working interview where you can see those skills in action.

As you dig into learning, the satisfying layers of simplicity will peel away, and confusing complexities will become apparent. “Hmm. Customers like some modern-designed products but not others.” “That’s strange. The company actually earned less during the last construction boom due to safety problems.” “The candidate performed well on the skills, but was late for the working interview and seemed defensive about feedback.” Not so simple now.

The confusion that comes from digging into new learning might be an uncomfortable feeling. We can avoid confusion by relying in ignorance on simple, sensible stories. We can also reduce confusion (to a point) by gaining deep understanding of a subject or situation. On the learning curve between ignorance and deep understanding, we have to travel through confusion. This unpleasant mental discord that comes with the learning process is a good sign. It means you are moving closer to understanding the reality of the situation, and it also serves to protect you from the overconfidence that comes from trusting a simple storyline.

You are more likely to make an investment mistake when you know a few satisfying storylines than when you are engaged in a confusing learning curve. The feeling of confusion is a valuable signal that you need to learn more before deciding. Simple stories, on the other hand, eliminate confusion without adding actual understanding, and believing them is asking for trouble.

Research and testing will dispel simple stories, and help you see the complexity you must grasp to make an informed decision. Investing the time to thoroughly understanding an opportunity will lead to an investment advantage.

Embrace Not Knowing

At one of Berkshire-Hathaway’s giant shareholder meetings, I heard an audience member ask Warren Buffett and Charlie Munger what they thought about the new electronic currency BitCoin. As I recall, Munger said, “I don’t have any idea about the value of a BitCoin,” and Buffett said, “I don’t either. Berkshire won’t be investing in BitCoin, I can tell you that. We know what we don’t know.” Next question.

Some investments are so speculative or uncertain, deep understanding of their prospects isn’t possible. Other times thorough understanding is possible, but the cost of learning about an opportunity outweighs the potential returns.

If it doesn’t make sense for you to spend the time to go through the learning curve, that’s okay. That probably means you shouldn’t make a decision about that investment either. Effective investors frequently walk away from opportunities they don’t understand.

Most investments will fall into this category for most of us. We have many opportunities to be seduced by simple storylines, and many opportunities to admit what we don’t know and stay out of trouble.

As an investor, you must be able to tell the difference between the illusion of competence from shallow storylines, and a realistic basis for confidence based on deep understanding.

Learn to recognize and be honest with yourself about areas in which you don’t have thorough understanding. Reject simple storylines that temptingly offer to bring meaning to that knowledge gap. Just say “I don’t know.” Dig deeper to learn more, or look for investment opportunities you understand better.

Understand the Lifeblood of a Business

You understand how a business is performing by understanding its accounting. You understand why it’s performing that way by understanding some other things.

What’s the economic engine at the core? This is where value gets created. Like the engine in a car, this is where the economic power comes from that drives everything else. In a manufacturing business it’s on the assembly line, where the whole product almost magically becomes worth more than the sum of its parts. In an insurance business it might be the ability to accurately price risk, and the financial capacity to take those risks. In a brokerage business the engine at the core might be sales made through trusting relationships. Understanding the core value generator(s) is an essential part of thoroughly understanding a business.

How do people treat each other there? This is the culture of an organization. Many organizations with smart strategy underperform or fail completely because the employees, customers, or other people involved don’t like how they are treated. Is it a competitive culture, a collaborative culture, or a nurturing culture? Does that culture fit the company strategy and the customers’ needs?

What’s the competitive advantage? Do people want what they sell? Do customers have solid reasons to choose this business over another provider? What, if anything, do they do that’s hard to imitate?

All these taken together build a framework for thoroughly understanding a business. This applies to a solo business, a small family business, or a giant corporation. When you can answer these questions in an informed way, you have an advantage in making investment decisions about that business.

Understand What You Are Involved In

Our most important investments are usually more integral parts of our lives than owning stock in a large and distant corporation. With thorough understanding we’ll make better decisions about closer-to-home arenas like our households, our friendships, our jobs or businesses, and our own training and development.

I review financial results from each of my companies a day or two after month end. On a daily basis I look at graphical dashboards of key performance indicators like sales, backlog, capacity utilization, and advertising response. These businesses are my most important financial investments. I keep the information to understand how they are doing close at hand.

My wife does a great job faithfully accounting for every dollar we spend from our household budget. Each New Year’s day we meet to review what we spent in the past year, and decide what to budget for the year ahead. (This holiday activity may give you a glimpse into what a fun-loving person I am.) The accounting my wife does gives us the thorough understanding we need to make informed decisions about our personal consumption. Understanding via accounting enabled sound management of our household finances, which played a key role in our overall investment capability and results.

I’ve noticed entrepreneurship and a love for accounting sometimes don’t coexist in a given individual. If you are investing in your own business, you need to understand the key accounting measures of that business. You don’t need to do the accounting yourself, but you better read and understand the numbers that describe the state and performance of the business. Understanding the financial metrics of a close-to-home business is probably even more important than understanding the finances of a public company, in which more accountability and analysis are in place.

Financial investing without good financial accounting is like painting a portrait in the dark. It might keep you busy for a while, but when the lights come on, it’s gonna be ugly.

It goes without saying that you need to understand the terms of a car loan, employment contract, or life insurance policy before you commit to it. Thorough understanding and wise decisions in such close-to-home financial matters often make a bigger difference than scrutinizing investments you are less personally involved in.

Understanding isn’t just for financial investments. It applies to investing in relationships with people, whether friends, employees, or a future spouse. Don’t rely on first impressions or simple storylines about a person’s character. Seek to know people more thoroughly before you trust too much.

Understanding applies to investing in your own development, too. Seek to understand your own fears, desires, strengths, and history. Ask people around you for feedback and insight about how you behave and interact.

Take time to learn and understand beneath the surface, and you’ll make better decisions.

Action Points

  Maintain a grounded awareness of the limits of your understanding: which investment decisions are in areas you thoroughly understand, and which investment decisions are outside of those limits.

  Approach decisions with extra caution in areas in which you don’t have thorough understanding, but you do know enough to be dangerous.

  Don’t be lulled into a false sense of understanding by simple, plausible storylines that mask decision-relevant complexities. Dig deeper, or admit you aren’t qualified to make investment decisions in that area, and move on.

  Invest in attaining thorough understanding by engaging in learning. Reduce risk and increase ROI on your learning experiences by doing small-scale experiments, not big ones.

  Access and understand financial accounting for your household, and any businesses you invest in. Understand the economic engine at the core, the organizational culture, and the competitive advantage of those businesses too.

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