I once read that some analysts' valuation models extend out for 20 or 30 years. In an uncertain world, this seems like a recipe for disaster -- it's hard enough to predict the next quarter's earnings. To succeed, investors need to learn how to deal with uncertainty.
Accuracy vs. precision
Economist John Maynard Keynes once said, "I'd rather be roughly right than precisely wrong." Fools should follow suit when evaluating investment opportunities.
Investors often confuse precision with accuracy. If you asked how many people there are on Earth, an answer of 5,345,342,993 might seem extraordinarily accurate. It's not. A much less precise -- but more accurate -- answer would place Earth's population at roughly 6.6 billion people.
This fallacy happens in the real world, too. Various risk modelers, who rely on relatively precise data, estimated Hurricane Katrina's losses between $10 billion and $26.5 billion, but the actual loss was around $40 billion. Although precision produces nice numbers, it often lacks accuracy. In other words, if you concentrate too much on individual trees, you might miss the forest.
Knowable vs. unknowable
To deal with uncertainty, you've also got to separate the things you can know from the things you can't. Pascal's infamous wager conjectured that if you're uncertain whether God exists, you might as well "bet" that He does. Pascal deduced that proving God's existence would be impossible. Faced with the chance of being wrong and facing eternal damnation, he argued that it'd be wiser to err on the side of caution, and believe.
Investors should similarly weigh the risks, rewards, and consequences of their actions. As the subprime debacle wreaks havoc on balance sheets, investors need to deal with the market's uncertainty about subprime exposure. That doesn't mean Fools should automatically rule out investments in companies with subprime exposure, like Countrywide
Margin of safety
How can you find the stocks best prepared for the worst-case scenario? By looking for a margin of safety. In the homebuilding industry, for instance, potential investors face the uncertainty of a prolonged housing slowdown, falling land values, and a shaky and illiquid credit market. Thus, investors should only seek homebuilders whose great balance sheets provide ample armor against even the most dire economic situations.
For example, Motley Fool Hidden Gems pick MDC
Investors need to ask themselves several key questions: What if my assumptions are wrong? What's a conservative margin of error? If the stock price still makes sense under worst-case scenarios, it might be time to pull the trigger.
The bottom line
Although we live in an uncertain world, intelligent investors can increase their odds of superior long-term results by following these simple steps:
- Seek situations that only require you to be vaguely, rather than precisely, accurate. Don't be duped by false precision.
- Diligently weigh the risks, rewards, and probabilities in every investment. Separate the knowable from the unknowable, conservatively assume the worst in uncertain scenarios, and then look for bargains.
- Lastly, always seek stocks with a margin of safety.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool's disclosure policy deals only in known knowns, as opposed to unknown knowns.