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Know What You Don't Know
And focus your efforts on what you do know--or can figure out. That may seem like obvious stock market advice, but many investors don’t follow it. They spend considerable effort on trying to predict factors and forces that are almost beyond the possibility of accurate prediction. As a result they try to get in and out of the stock market at just the right times, to predict what the economy is going to do or to forecast where interest rates are headed, among other unknowables.
Instead, we believe you are better off not trying to time the market, but choosing a level of stock market exposure with which you are comfortable and sticking with it. Then you can focus your efforts on thorough fundamental analysis of stocks that look interesting to you. While very few things about investing are known for certain, your chances of accurately predicting one company’s earnings or determining the sustainability of its balance sheet are much better than forecasting major market moves or economic shifts.
That’s not to say that you should completely ignore these significant unpredictable factors in your analytical process. Rather, you should consider several possible outcomes in these areas and use those outcomes to test the conclusions coming out of your focused fundamental research. For example, when you think a stock looks pretty cheap in a certain economic environment (your “base case” scenario), you should consider what will happen to it if the economy is weaker than you expect (a “worst case”) or if the economy turns out to be stronger than you expect (a “best case”). You can then weigh the risk of loss in the worst case scenario against the possibility of gain in the base case and best case situations and decide if it seems like a reasonable investment given your personal tolerance for risk. This sort of stress testing can also be done with other macro forces that may be relevant to the particular stock, such as interest rates or oil prices.
An important corollary to knowing what you don’t know is “Don’t worry too much about what you don’t know.” Some investors become paralyzed by concerns about the unknown. They are so worried that they don’t know which way the market (or interest rates or the economy or whatever) is going next that they don’t do anything and their portfolio suffers. While you should always take reasonable steps to minimize risk--such as being diversified--there will always be risks in investing, and you just have to plow ahead regardless. As the old saying goes, “Nothing ventured, nothing gained.” Moreover, in most circumstances, returns are proportional to risk over the long-term, and so the more risk you can tolerate, the higher your returns are likely to be.