In his excellent book Ignorance: How It Drives Science, Stuart Firestein writes:
Scientists don't concentrate on what they know, which is considerable but also minuscule, but rather on what they don't know ... Forget the answers, work on the questions ...
Being a scientist requires having faith in uncertainty, finding pleasure in mystery, and learning to cultivate doubt. There is no surer way to screw up an experiment than to be certain of its outcome.
The theme of Firestein's book is that ignorance in science is a virtue. What scientists don't know sparks questions, fuels imagination and leads to experiments that ultimately expand the universe of what we do know. The center of attention is what you don't know but are trying to figure out.
Many investors, I feel, take the opposite approach. They focus relentlessly on what they do know, and treat suggestions that they don't know everything as an attack on their existing beliefs (anyone familiar with the comment section of articles knows what I mean). They have their answers, and find no need for questions.
Three years ago, the S&P 500 (SNPINDEX:^SPX) was at 1,000 and had a cyclically adjusted P/E ratio of 23, which some noted was 60% above its long-term average. Stocks, therefore, were bound to fall. Many were sure of it. They had their answer, and no need to ask further questions.
Three years later, the market is up more than 60%, and the P/E ratio has barely budged.
The huge body of what we didn't know -- how much earnings would rise, how much the economy would recover -- turned out to be much more important than we did know, the P/E ratio in 2010. Investors' experiment of not owning stocks for the last three years "screwed up," in Firestein's words, because they started off certain of its outcome.
Apple (NASDAQ:AAPL) is likely the most innovative company of modern history. A year ago, investors were rigidly convinced that a combination of superior products, fast growth, and what looked like a cheap stock meant Apple shares could only go one way: up. Analysts had an average price target of nearly $900 a share. They had their answers, and no need to ask further questions.
But shares are down 29% in the last year, and they trade at less than half analysts' average price target. The stuff we didn't know a year ago -- the dynamics of competition, investor appetite for other assets, etc. -- became much more important than what we did know back then.
Both of these observations are only possible with the advantage of hindsight. But that's precisely the point. Some of the most important variables that will determine where stocks go are things we just don't know today. But many investors don't think like that. They take what they know and assume it's what counts.
Blogger Shane Parrish borrows the term fragilista from Nassim Taleb to describe this type of thinking, and writes:
Fragilistas are naive rationalists. They think that the reasons for things are, by default, accessible to them. They know the cause and effect of everything, or at least that's what they think.
Because they mistake what they don't know for the non-existent, they exhibit a strong -- if mistaken -- regard for the powers of reason. They lack humility and respect for the first law of ecology: we can never do merely one thing.
Any action we take, and in this case inaction is a course of action, results in some unwanted consequences.
Food for thought.