Annie Duke once said, uncertainty is where things happen; it is where the opportunities for success, for happiness, for really living are waiting.
In “Thinking, Fast and Slow,” Daniel Kahneman discusses two different levels of thinking in the human brain.
System 1 thinking is automatic, fast and instinctive. This type of thinking can be fast and convenient but can lead to inaccurate conclusions and missed opportunities because of its reliance on common beliefs.
System 2 thinking, on the other hand, is slow, deliberate and conscious. It involves more effort and cognitive resources than Level 1 thinking and is used when we need to reason through a problem or make a complex decision.
It involves going beyond the superficial, surface-level understanding of a situation to consider the deeper, underlying factors that can affect its outcome.
Warren Buffet, for example, invested in Apple using System 2 by asking the following questions:
How many names in global equity are going to be 15 x earnings in the next 12 months?
How many are going to earn more in five years (using a 90% confidence interval), and how many will compound at 10 to 20% (using a 50% confidence interval)?
In this exercise, you are solving for cyclicality, compounding, and initial price.
This analogy was used to find Apple since at the time the same 3 to 5 names kept coming up.
By engaging in this type of thinking, investors can gain a more nuanced understanding of a situation and make better decisions.
The third little-known Apple co-founder
In 1976 Ronald Wayne, Apple’s third co-founder sold his 10% stake in Apple for $800.
Today that stake would be worth around $250 billion, which would make him one of the richest people on the planet if he hadn’t sold his stake in Apple.
But Wayne now lives in a mobile home park in Pahrump, Nevada where he sells stamps and rare coins and plays penny slots at a casino.
Being comfortable with uncertainty
What we learn from Wayne’s decision is that as investors, we should accept that the future cannot be predicted with absolute certainty.
Therefore, being comfortable with uncertainty is the key first step to long-term success in investing because the world is unpredictable.
Students were told by Warren Buffet the most important quality is temperament because it permits the control of fear and greed which have ruined many lives.
Anyone who becomes rich twice is dumb.
Why would you risk what you need and have for what you don’t need? If you are already rich, there is no upside to taking on a lot more risk, but there is a disgrace on the downside.
However, Wayne’s story is about his risk-averse attitude due to his experience five years prior with the failure of his slot machine business and the debt he had spent one year voluntarily repaying would fall on him. That led him to watch the opportunity slip away.
The key to decision-making is to maximise the bet when you have a big edge and bet small when you have less of an edge. In other words, if the expected value is greater than the cost then you have a positive expected value.
The longer your time horizon in the stock market, the better. When investing in the S&P 500 in the short term, your odds of making money are much lower, but when you look at it over the long term, you have a much better chance of making money.
Knowing the difference will enable you to make wise decisions when the world offers you tremendous opportunities.
Finally, the world’s a pretty random place and the influence of luck makes it hard to predict how things will pan out, especially with hidden information and our cognitive biases.
As Benjamin Graham said, intelligent investing is not about being right all the time. It’s about constantly learning and improving your decision-making process.
Embracing uncertainty and being open to new information can lead to new opportunities and experiences in life.
Awet Ghirmay, Head of Investment Research
If you’re interested in learning more about this topic, please find the link here.
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Risk warnings
*The value of investments and the income derived from them may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs practice. Levels and bases of tax relief are subject to change. This blog is based on my own observations and opinions.
