Unknown knowns

Stocks that do particularly well leave investors in awe, wondering whether they could have predicted the appreciation. The Efficient Market Theory says that is impossible. Only news can move stocks prices. Hence, those stocks must have appreciated for reasons that were unknowable in advance. Nothing that was known before the price move could have helped to predict it.

This is true in many cases. But it is not always and necessarily true. The EMT is wrong: spotting bargains in advance is a difficult but not impossible task. To its credit, however, while it gives the wrong answer, the EMT does ask the right question: if you are predicting that a stock will appreciate, what do you know that the market doesn’t?

Answers to this question can be pretty weak. As ex US Secretary of Defense Donald Rumsfeld famously said:

There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.

Known knowns are useless at predicting price moves. In this respect the EMT is right: what everybody already knows must be reflected in current price levels. Thinking otherwise is what Howard Marks calls First-level thinking – definitely not a good investment method.

Known unknowns are what most investors spend their time thinking about. Taking the current price as given, investors use all sorts of information trying to predict what is currently unknown but will likely cause a price change in the future, once it becomes known. Here the EMT is wrong: the fact that information is available does not mean that everybody has the same expectations. People interpret information in different ways and can draw different conclusions from the same evidence. However, while predicting the future can lead to investment success, it is also fraught with risks, as the future is highly uncertain, often more than we are lead to believe.

Unknown unknowns are what Nassim Taleb goes on and on about. The unpredictable can happen. But, apart from writing books, there is not much one can do about it, other than trying to figure out as much as possible, being aware of the risks and avoid overconfidence.

But there is a fourth element in Rumsfeld’s matrix:

Unknown knowns are things that we are not aware we know. It is available information that we fail to take into account because a blind spot prevents us from seeing it. The Prior Indifference Fallacy renders the Base Rate an unknown known. Prior indifference explains the power of experts – be it a confident coach saying that your child is a champion or Mr Market saying that the price is right.

Investors who take the current price as given and focus entirely on predicting the future are likely to miss the best and safest opportunities for spotting bargains. Rather than trying to predict where the price will go tomorrow, investors are better off thinking where it should be today, allowing for an ample Margin of Safety.