Do you know what you don’t know?

 
This post, as regular readers know, is about one of my favorite subjects. To be more precise, it is about our own lack of understanding of our own lack of understanding. From the original work by Daniel Kahneman and Amor Tversky, as laid out in their famous 1974 paper “Judgment under Uncertainty,” to the Dunning-Kruger concept of metacognition — the specific skill needed to recognize one’s own skill set — this foible continues to be of great importance to investors. O’Shaughnessy starts his discussion on a note of humility, writing there are “some things I think I know and some things I know I don’t know.” That simple observation places him ahead of oh, say, 80 percent of all investors. This is not how way too many investors think.

The first step is recognizing what it is you know you don’t know. For O’Shaughnessy, this begins with the simple question, one that is asked every day by financial journalists in print and especially on television, discussed among retail stock brokers, and debated by fund managers: How will the market perform this year or next? This is often paired with a related question: Will stocks be higher or lower in five or 10 years? O’Shaughnessy notes what the probabilities are — stocks do tend to rise over time — but then says he can’t say with any degree of certainty if stocks will indeed be higher a decade from now. ²

This acknowledgement alone bumps him up to the 90th percentile of wisdom among investors.

Most people don’t even try to envision what they don’t know. This brings to mind, of course, that felicitous phrase coined by former U.S. Defense Secretary Donald Rumsfeld, “unknown unknowns.” The human brain, marvelous as it may be, has a blind spot for these. But, truth be told, the universe of what we don’t know is beyond our grasp, even though we tend to fool ourselves into thinking we know more than we do.

This brings to mind something Rob Brotherton, an academic psychologist,  described in his book “Suspicious Minds: Why We Believe Conspiracy Theories.” Citing University of Michigan professor David Dunning, half of the duo behind the Dunning-Kruger effect, he wrote:

An ignorant mind is precisely not a spotless, empty vessel. It’s filled with information — all the life experiences, theories, facts, intuitions, strategies, algorithms, heuristics, metaphors, and hunches — our brain indiscriminately uses whatever is at hand to plaster over the intellectual blind spot.

This is an enormous problem, not just for those who believe that the moon landing was faked, but for investors as well: indiscriminately plastering over the “intellectual blind spots” leads to terrible outcomes in markets. Our lack of awareness of our ignorance may be the enabling cognitive bias that leads to all other investment errors.

That raises some questions all investors should ask themselves from time to time. The second most important is “What am I wrong about?” while the most important is “What do I have no idea I am wrong about?”

The trends of the past decade strongly imply that investors are starting to not only understand this, but change their own behavior in response.

I believe that sending trillions of dollars to low-cost index funds run by Blackrock Inc. and Vanguard Group Inc. is a sign that investors are growing more aware of their cognitive limitations. It indicates, to borrow from Rumsfeld again, a Known Knowns: That costs matter, and that as a rule of thumb, the lower the fee the better the long-term performance. Generally speaking, passive is much cheaper than active.

Investors have also come to recognize their own inability to pick outperforming money managers — a “Known Unknowns.”. Last, the financial crisis of 2008 also taught us that nearly all people lack the ability to anticipate how they themselves will respond in the future to unknown market conditions — this is a “Unknown Unknowns.”

O’Shaughnessy wraps up his tweet storm by noting “While I think I know that everything I’ve just said is correct, the fact is I can’t know that with certainty . . . history has taught us that the majority of things we currently believe are wrong.”

Admitting the possibility of not knowing something, recognizing how much we are ignorant of, is the first step toward preventing the kinds of overconfidence and assumption of omniscience that is so damaging to investors.

26/Finally, while I think I know that everything I’ve just said is correct, the fact is I can’t know that with certainty and that if history has taught us anything, it’s that the majority of things we currently believe are wrong.

— Jim OShaughnessy (@jposhaughnessy) May 10, 2018

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1. Disclosure: Some clients of Ritholtz Wealth Management are invested in O’Shaughnessy asset management funds.

2. Although the philosophical implications of this are intriguing, the data geek in him can’t avoid the numbers: “Since 1945, there have been 77 market drops between 5% and 10% and 27 corrections between 10% and 20%.” O’Shaughnessy notes this is a “feature, not a bug” of markets.

Originally: A Tweetstorm That Every Investor Should Read