"I Have No Idea"

In his book The Quest of the Simple Life, William Dawson tells the story of an exam at a 19th century London prep school. One question asked was, "Give some account of the life of Mary, the mother of our Lord."

Dawson wrote, "One bright youth responded, 'At this point it may not be out of place to give a list of the kings of Israel.'"

This was a common problem at prep schools. Students were not trained to think. They were taught to recite specific facts and formulas. Anything requiring creative thinking left them dumbfounded. To them, there was basically no world outside of the facts they had memorized. Faced with any question, they responded, often absurdly, with the only facts they knew, Dawson wrote.

I had dinner earlier this week with the portfolio manager of an endowment fund. We talked about a problem in finance: Some of the smartest people we know are abysmally bad investors. Not just average, but abjectly terrible.

We agreed that the cause of this quirk was the same problem faced by 19th century prep-schoolers.

The smartest people we know are geniuses at fields where you can memorize facts and formulas. But any problem requiring squishier, creative thinking is unchartered territory. When faced with these problems, they inject the only thing they know: the facts and formulas they were taught to memorize. 

These people are textbook geniuses, but they don't know the limits of their intelligence. Or even the context of their intelligence. And that's just as bad as being stupid.

There are economists -- very smart ones -- who said there was a 100% chance we'd have a recession in 2011. There are brilliant investors who have been certain since 2009 that the market is inches away from collapse.

They made these predictions because they are trained math geniuses who created statistical models showing that these events were certain to occur.

But there is an infinite amount of stuff in finance that can't be answered with math, facts, or formulas. There are things we can't measure, and things we can't understand, ever. Herd behavior, future trivia, and psychology aren't things we can predict today. It's just insanity and chaos.

That's not acceptable to you if you've been trained to measure things with facts and formulas. Just like the prep school student, there is no world outside of the facts you've been trained to memorize. So you try to predict human behavior with standard deviation, or the decisions of a despotic dictator with a bell curve. And you fail, virtually every time.

Realizing the limits of your intelligence one of the most important skills in finance. P.J.O'Rourke described economics as "an entire scientific discipline of not knowing what you're talking about," which is pretty accurate. When you pretend you know something you don't, your perception of risk becomes warped. You take risks you didn't think existed. You face events you didn't think could occur. Understanding what you don't know, and what you can't know, is way more important than the stuff you actually know.

In that sense, the four most important words in investing are probably, "I have no idea." 

I have no idea what the market will do next.

I have no idea if we'll have a recession this year.

I have no idea when interest rates will rise.

I have no idea what the Fed will do next.

Neither do you.

The sooner you admit that, the better. 

Check back every Tuesday and Friday for Morgan Housel's columns.