“Buy things that you understand”, “Stick to what you know”, or “Stay within your circle of competence” – We hear these advises all the time so we don’t invest in stocks we know little about. But what define understanding? How do we know if we truly understand a business? If I know Apple designs, develops, and sells consumer electronics and computer software, is that enough to say that I understand the business? Or is it something more? Before we can set a parameter to separate understanding from the lack thereof, we should first understand why is it important to know a business. The reasons are both psychologically and analytically.

Put it simply, you want to understand a business so you’re not psychologically disadvantaged when the market goes against you. If you don’t know what you’re doing, there’s no way to plan and prepare. And when you’re not prepared, it’s easy to be surprised because you’ve no idea what can possibly happen. No one like surprises. Surprise create anxiety. How do we avoid surprises? We follow the market. You stay on top of the market so you can react fast. When the market moves, you want to know why. Since you don’t know much about the business, you rely on the daily share price to tell you what to do and get influenced by the market in the process. Hence, when something goes wrong, you tend to follow the crowd to sell assuming the market knows more than you. Occasionally, you decide to bet against the market. Instead of following the crowd, you look for supporting information to convince yourself that you’re right and the market is wrong. It is another way to avoid pain under a stressful situation by reassuring ourselves that our decision is correct. You become close-minded and force reality to fit into your own beliefs. You feel vindicated when the market turns your way. You become more interested in being right to uphold your ego than making the best decision. Whether you decide to follow the crowd or go against it, the outcome is clear. If you buy things you don’t understand, you’ll always be at the mercy of the market and fool yourself into making silly mistakes.

Understanding a business also improves the accuracy of our forecast. Consider this. You stand a better chance of correctly guessing a person’s age than say, the age of an emu. Why? Because you grow up together with other people. Over the course of your life, you acquired many reference points such as hair color, wrinkles, skin tones through interaction with others. These reference points create a mental model of how one should look like at a specific life stage. In contrast, unless you’re a zoologist, you probably know nothing about emu other than it is a huge bird. Your estimation will be totally off even if you have a huge margin of error. It is like move the Hubble space telescope an inch and you’ll be looking at the other side of the universe. You don’t know the average lifespan of an emu, therefore, much less to estimate how one should look like at any given age. Similarly, when you buy something you don’t understand, your forecast on the value of the business is going to be wrong most of the time. To make it worse, you rely on the share price as the reference point to prop up your confidence and make decisions. When the price goes down, you tell yourself “Buy at the dip” or “The market overreact”. When the price goes up, you take that as an indication that you’re right. You create an illusion of understanding thinking you know what you’re doing.

Now we have a basic idea why understand a business is critical—It increases forecast accuracy and reduce mistakes—we can create a guideline that defines the parameter of understanding. This guideline can be turned into 2 simple questions:

1. What are the risks that can cause the business to suffer a loss in earning power?
2. Have you included these outcomes in the valuation to derive an expected value?

The first question deals with negative surprises. As an example, all utility companies carry regulatory risk. A change in utility regulation can potentially impact the earning power of these companies. So, you have to ask, what needs to happen for this (regulation change) to be true? It could be a change of government, monopolistic industry, the emergence of new technology i.e clean energy, or a combination of these factors that increases regulatory risk. Once you’ve identified the risk factors associated with the characteristics of the business, you can prepare and plan ahead so when something goes wrong, instead of panic and rely on the market for direction, you can rely on your investment process to make the best decision.

The second question builds on the first. Your forecast is going to be more accurate when you consider all the possible outcomes and synthesize them into your valuation as opposed to only think about what you think will happen. Building on the example above, a change in utility regulation is a possible outcome. You’ll have to ask, what is the likelihood of that happening? And if it happens, how will that affect your valuation? It is difficult to know what’s the likelihood, much less so to know the effect on valuation since the change can either be good or bad. Nonetheless, the accuracy of your forecast will improve when you see things from multiple perspectives.

The objective of understanding a business is to improve judgment, stay prepared, and reduce mistakes. But the definition of understanding can mean different things to different people. Not to mention it is easy to rationalize our way when there’s money to be made. Therefore, these two questions can serve as a parameter to assess the level of our understanding, tame overconfidence, and improve return.

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