Knowledge or experience?

Knowledge or experience?

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We live in an age in which huge quantities of information are available instantly at the touch of a button.  It has never been easier to acquire knowledge, assuming that we have the time to filter through it to find what we want.  A visit to the newsagent, bookshop, or even just a search on the Internet will bring up many examples of supposedly helpful advice and guidance on how to improve our financial position.

While this is beneficial in many ways, it may come as a surprise to learn that with investing, having more knowledge is not necessarily helpful when it comes to making sound decisions about how to structure and manage our portfolios.  Indeed, with markets having moved considerably higher than they were when the potential impact of the pandemic was appreciated in early 2020, most investors will be showing gains since that low point.  Since most investments have been successful, it is easy for their owners to feel that they possess knowledge about how to invest effectively.  However, an asset whose price has risen is merely an asset which has become more expensive than it was.  Buying expensive assets gives the previous owner the benefit of the gain but runs an increased risk of future returns being lower.

We have, of course, been here before.  History is littered with examples of market mania in which rising prices result in increasing confidence, more investment and ultimately, a bubble.  Whether it was the 17th century Dutch tulip mania, the South Sea Bubble in the 18th century, or the tech boom and bust of 2000-01, the driver is a combination of greed and a fear of missing out on supposedly easy profits.  Most recently, we have seen the GameStop episode in which small investors apparently day traded their way to wealth at the expense of big Wall Street firms.

Humans, for whatever reason, appear to be extremely prone to looking at a chart which measures the progress of something over time and projecting forward a trend at the same sort of rate.  Regardless of the fact that the chart may show significant reverses in previous years, the idea that ‘this time it is different’ can be hard to resist, particularly if the one telling story has an interest in promoting that particular message.  Such a tendency is not restricted to investment. 

Hans Rösling’s excellent book ‘Factfulness’ makes the point that it is also applied when looking at population data.  For example, armed with the knowledge that birth rates in developing countries are higher than in developed countries, and given a global of finite size, they can be used to show that the world will become overpopulated.  However, in what are now developed countries, birth rates also used to be higher.  This was not because people necessarily wanted large families because they liked children as much as the fact that high infant mortality rates and concerns about care in old age implied a need to maximise the chances of at least somebody being there to look after adults in the future.  As health care and financial security improved, those children now had to be educated and that is a lot more affordable with one or two children than with 10.  Consequently, with a reduced need to guard against the possibility of infant mortality, birth rates fell.  We should not be surprised that the same trend applies to people in developing countries and as a consequence, population growth tends to slow down as economic development takes place.

While it is obviously easier to spot market bubbles after they have occurred, there are several indicators that are common while they are still in existence.  These include:

  • A widely held view that ‘this time it’s different’;
  • An increasing frequency of initial public offerings;
  • A huge expansion in the activity of retail traders;
  • Investors are willing to purchase companies at increasingly large multiples of their profits (or even infinite ones in the case of those which are loss-making);
  • An increase in the incidence of investors buying on margin and
  • An increase in speculation using derivatives.

When the bubble eventually bursts, as bubbles invariably do, those traders who behaved as though they were playing the tables in a casino are the ones left broke while the long-term participants acquire a bit more knowledge to help them the next time it happens.  The traders, meanwhile, disappear.  Still, if there’s one thing on which we can rely, it is that at some point in the next market cycle, a further batch of hopefuls will take their place and repeat much the same scenario.

Yet for the long-term investor, what separates success from failure is the appreciation that knowledge and experience are different.  Experience is what we learn from observing and as a result of connecting multiple pieces of knowledge to form a framework which helps us when making future decisions.  This is why bear markets can be more valuable for those who are investing rather than speculating.  The record is there for anyone to study and allows all investors to use them to construct a set of overriding rules to govern their relationship with the market.

Key to constructing such set of rules is to have a clear understanding of the concept of risk.  For most people, investment risk is the possibility of losing money.  However, there is also opportunity risk, which is the risk of missing an opportunity of making money.  Since it is possible to eliminate one of these risks but not both, the most important decision for any investor is where on the spectrum between the two they wish to position themselves.

Once you have made that decision, you also need to assess the extent to which you are an emotional person.  Being emotional does not make you either good or bad but it does make it more difficult to be an effective long-term investor.  This is because emotional people are more likely to be influenced by news flow and therefore to buy high when everyone is euphoric.  Conversely, when prices fall and doom and gloom predominate, they are more likely to sell.  If there is one formula for losing money when investing, selling for a lower price than you paid in the first place is about as good as you can find.  Most investors are able to make their decisions with minimal emotional involvement so if you find that you struggle to do this yourself, maybe you should consider enlisting a professional who can do it for you.

One of the old axioms that eloquently illustrates the importance of experience is that when someone with money meets someone with experience, the one with the experience leaves with the money and the one with the money leaves with experience.

Which one do you want to be?