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How Ignorance might Save You from Losing your Money

Credit: William Ross

In 2011, a survey was conducted by American car insurance provider AllState for drivers to rate their own driving ability and driving habits. The completed survey revealed some interesting bits, including an amusing one below:

“American drivers believe their own driving knowledge, ability and safe driving habits are well above other drivers on the road. Nearly two-thirds (64 percent) of American drivers rate themselves as “excellent” or “very good” drivers.”

Now, our Foolish readers would immediately catch on that there is no statistical way that a full 64% of American drivers can be “above average”. Sadly, it was more likely that the drivers surveyed were overconfident of their own skills, and quite possibly, did not realize it.

Unfortunately, the same overconfidence may affect investors as well. In fact, fellow Fool Morgan Housel once called out overconfidence as an investor’s greatest enemy .

Known unknowns

Ignorance is defined by Merriam-Webster as “the lack of knowledge or understanding”. Therefore, as a first step in avoiding overconfidence, we may want to identify our own areas of “known unknowns”, or knowing what we don’t know. Said differently, we have to be able to first acknowledge our own areas of ignorance.

If we can begin to come to terms with this, then we may move on to think of the appropriate steps that is needed to cater for our blind spots in knowledge.

Let’s use MTQ Corporation Limited (SGX: M05) to illustrate this point. This week, I wrote about the three business segments which drive the revenue of this oil and gas equipment services company. For MTQ’s last completed financial year, its Engine Systems division made up 15.6% of  total revenue but only contributed 6% to total profit.

A possible scenario could be that a Foolish investor considers the prospects of the Oil Field Engineering division of MTQ to be attractive, but at the same time, acknowledges his or her lack of understanding in the Engine Systems division. Under these circumstances, the Foolish investor could still decide to go ahead and invest in the company as the Oil Field Engineering division provides almost 80% of the company’s profits.

But to do so, a pragmatic approach might be to either size the initial cash allocation in smaller increments, or demand for a deeper discount in share price to cater for the investor’s own “known unknowns”. This approach may be tailored to the comfort level of each individual investor.

Ergo, the awareness of your own areas of ignorance may just keep you from blindly taking outsized risks which you were not aware of. Outsized risks may lead to losses down the road.

Foolish takeaway

There is no human being with perfect knowledge about a business or industry such that he or she can predict the future consistently.

However, we can still work towards limiting errors or losses due to our “known unknowns”. By spending time to think through and acknowledge areas where we have less knowledge on, we can begin to manage risk in more structured way.

As everyone’s breadth and depth of knowledge will contain differences, it therefore follows that the level of risk for each investment might be personalized to each individual investor.

Beyond our own identified areas of ignorance, we still might want to have a margin of safety. After all, Carl Richards (the author of the Behavioral Gap) sums it up best when he said:

“Risk is what’s left over when you think you’ve thought of everything else.”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn't own shares in any companies mentioned.