Are there diminishing returns to knowledge? This unsettling thought popped into my head the other day when we were having a lively internal discussion about a particular stock we were contemplating buying.
I’ll spare you the details, but essentially the debate turns on a decision by an industry regulator which will have no impact on this company for the next two or three years, but which will – unless it is reversed – have some impact thereafter.
This gives us three “known unknowns” to deal with. We have to assess the likelihood that the regulator’s position might change; and we have to form some idea of the range of outcomes in hard money terms that might result from whatever decision might eventually be taken. And that’s just thinking about the company’s sales and profits; we then have to take some sort of view on how investors will react in the way they value those profits when setting a price for the company’s shares in the market.
This is what clients pay for. If you entrust your hard-earned savings to investment managers you have every right to expect that the decisions they take on your behalf should be based on deeper knowledge and a more thorough understanding than you yourself possess.
However, the difference between owning and not owning a particular stock is much more clear-cut than the infinitely subtle gradations of knowledge that lie between complete ignorance and the fullest possible understanding. (Note I don’t say “full understanding”; it is just not possible for anyone to know all that there is to know about the factors which are likely to affect the returns on a given investment.)
How far up the hierarchy of knowledge do we have to go in order to manage money successfully? Investment managers do their own research on companies in many different industries, but they also talk to specialist analysts who will cover in great detail the operating performance of companies in particular sectors.
For example, they may look only at brewing or life assurance or publishing, and within these sectors they might provide in-depth research on just ten or 20 companies. Although they know these companies better, they in turn will inevitably know less about each individual company than the senior management of that company. And even if you are running a business, your perspective will be different according to where you sit – managing director, sales, finance, operations – and it may not be the best place from which to assess whether the company’s shares are an attractive investment.
The clue is that there has to be a balance between precision and perspective. The more time you spend immersed in the details, the less time you can devote to understanding how your patch fits into the bigger picture. If you’re looking at one business in isolation, you might think it’s a good investment; you might be right, but you might not, and, crucially, you are not necessarily best placed to assess its merits relative to other opportunities.
The specialist, they say, knows a lot about a little; the dilettante knows a little about a lot; professional investors like me need to know enough about enough. Enough in the micro sense to appreciate the key forces which shape each company’s prospects. Enough in the macro sense to have a broad enough knowledge of the available opportunities to underpin a diversified portfolio.
There comes a point in the research process beyond which the hunt for more information begins to look like a displacement activity: something which you do, not to support a decision but to postpone having to make one. On and on we go, digging deeper and deeper for a golden key which probably doesn’t exist, for a door which isn’t even locked, but which you lack the nerve to open.
This is, as I said, an unsettling thought, because it reminds us that while ours is necessarily a fact-based discipline, the facts alone are not enough. Ideas without facts may be dangerous, but facts without ideas are useless. There are some managers who claim otherwise, who have set up mechanical processes in which defined factual inputs generate buying and selling decisions automatically – the so-called “black box” approach.
Well, each to his own, but I wouldn’t trust my own money to a system from which all traces of flexibility and common sense have been surgically removed. At some point, you just have to stop faffing around and get on with it.
l Gareth Howlett is fund manager director at Brooks Macdonald Asset Management