As Feynman puts it,
The question of doubt and uncertainty is what is necessary to begin; for if you already know the answer there is no need to gather any evidence about it.
I have approximate answers and possible beliefs and different degrees of certainty about different things, but I’m not absolutely sure of anything and there are many things I don’t know anything about.
The first source of difficulty is that it is imperative in science to doubt; it is absolutely necessary, for progress in science, to have uncertainty as a fundamental part of your inner nature. To make progress in understanding, we must remain modest and allow that we do not know. Nothing is certain or proved beyond all doubt. You investigate for curiosity, because it is unknown, not because you know the answer. And as you develop more information in the sciences, it is not that you are finding out the truth, but that you are finding out that this or that is more or less likely.
There are few absolute truths in investing. The best we can do is gather evidence as diligently as possible to assess the likelihood of various outcomes. We do this by connecting various pieces of the puzzle and trying to put them together in a way that makes sense. We are constantly exploring. We are constantly looking for new evidence—trying to find out more about what we know and to better understand what we don’t know.
After we gather the evidence, we must study the same. What did we learn? What does that imply for our original hypothesis? How likely is it that we are correct? Are there other factors we failed to consider that may have led to different results or conclusions? Investors are often too anxious to jump to conclusions that support their original thinking. Confirmation bias is difficult to resist. Again, we should learn from Feynman:
If we investigate further, we find that the statements of science are not of what is true and what is not true, but statements of what is known to different degrees of certainty: “It is very much more likely that so and so is true than that it is not true”; or “such and such is almost certain but there is still a little bit of doubt”; or, at the other extreme, “well, we really don’t know.” Every one of the concepts of science is on a scale graduated somewhere between, but at neither end of, absolute falsity or absolute truth. It is of great value to acknowledge ignorance.
Investors have a difficult time acknowledging the presence of uncertainty. But uncertainty remains the most fundamental attribute of financial markets. Living in an imaginary world of certainty can lead to potentially fatal mistakes in the real world of finance. The sooner we accept that we live in an uncertain world—that we don’t have all the answers—the sooner we can begin trying to become wiser. This understanding is vital. Once accepted, it shapes our worldview and becomes a natural way of thinking. Incorporating uncertainty in the way we think about what we believe creates open-mindedness to alternative hypotheses, moving us closer to a more objective stance toward information that does not align with what we believe—that is truth seeking.
With respect to investing, intellectual humility is best illustrated through the concept of the circle of competence.
The Circle of Competence
I’m no genius, but I’m smart in spots, and I stay around those spots.
—Tom Watson Sr.
Warren Buffett has always advised investors to focus on operating only in areas they understand best. In HBO’s documentary Becoming Warren Buffett, he compared his investing strategy to America’s favorite pastime, referencing baseball legend Ted Williams’s book The Science of Hitting, in which the all-star slugger emphasized the importance of knowing your sweet spot: “If he waited for the pitch that was really in his sweet spot, he would bat .400. If he had to swing at something on the lower corner, he would probably bat .235.”5
The lesson for investors, Buffett says, is that we don’t have to swing at every pitch: “The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!’ ignore them.”
Just as Williams only swung at pitches in his sweet spot, Buffett only invests in companies that are within his “circle of competence,” a concept he described for the first time in his 1996 letter to shareholders: “What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital [emphasis added].”6
This means that, as investors, we need to restrict ourselves only to those businesses whose long-term economics we can understand. For most investors, investing outside one’s circle of competence is what often leads to big losses. One should not blindly chase “buzzing stocks” or get swayed by exciting “stories,” “narratives,” or “futuristic” concepts, because these kinds of businesses usually have unproven track records or they lack profitability and cash flow.
The key idea behind the circle of competence is not its size—the absolute number of businesses you can understand—but your awareness about its size—the kind of businesses you know you can understand.
It is not important how big that circle is. What matters is how well you have defined its perimeter. Investors who are intellectually honest and humble are always willing to admit their limitations and to stay within their area of expertise.
So, how do you find your circle of competence?
Instead of picking what you know, use the inversion technique, popularized by Charlie Munger, to create your circle of competence. Inspired by the German mathematician Carl Gustav Jacob Jacobi, Munger explains,
Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead—through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.7
Try to know the things you don’t know, and then draw a circle that keeps those things out. (This is very much what scientists do. They approach a problem and its solution by trying to prove it is false, not that it is true.)
In investing, risk comes from not knowing what you are doing. In fact, Buffett considers this to be one of the biggest risks in investing. So much so that he avoids using equity risk premiums to value stocks, confining himself only to those situations about which he is highly certain. Buffett uses the interest rate of long-term U.S. Treasury bonds to value stocks, except when he believes it is artificially low. During those times, he adds a few percentage points to his discount rate. He says, “I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing.” In a similar vein, Buffett adds, “We don’t discount the future cash flows at 9 percent or 10 percent; we use the U.S. Treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”8
At the 1998 Berkshire annual meeting, Buffett explained how he thinks about risk when evaluating any business:
When we look at the future of businesses, we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don’t know what’s going to happen in the future, that doesn’t mean it’s risky for everyone. It means we don’t know—that it’s risky for us. It may not be risky
