Atul Gawande — surgeon and author of The Checklist Manifesto — recently delivered a speech at Williams College in the US. Gawande related how, as a young buck, he was impressed with the intricate skills of surgeons and that drove him to become a surgeon himself.
However, once he was in his surgical residency, he learned that those fine motor skills weren’t the key to being a top-notch surgeon. “Instead,” he said, “the critical skills of the best surgeons I saw involved the ability to handle complexity and uncertainty.”
If there are two things that investors eternally grapple with, it’s those twin demons of complexity and uncertainty. The speech got me thinking: How do I deal with complexity and uncertainty in my investing? Here are four strategies that I use.
1. Look for signposts
It’d be nice to claim a full, nuanced grasp of all the moving parts of one of the most well-known US companies, Berkshire Hathaway. Berkshire is a company with huge, complex insurance operations that span everything from plain-vanilla auto insurance to massive specialty catastrophe coverage. Fully understanding that alone would be an impressive feat. But Berkshire is also the owner of one of the U.S.’ largest rail systems, a multibillion-dollar portfolio, a regulated power company, and a wide array of individual businesses including Fruit of the Loom, Dairy Queen, and See’s Candy.
There’s some serious complexity for you.
A complete understanding of all of the complexities of a company like Berkshire may be out of the question, but what we can do is look for signposts of a successful company. For financial companies like Berkshire, for instance, book value is a key measure. For the decade ending in 2011, Berkshire grew its book value at an average annual rate of 11% per year, an attractive rate for a company that size. For other companies you may look at metrics like return on equity,revenue growth, profit margins, or balance sheet strength.
Investors have heard over and over again, “Past performance does not guarantee future results,” but by looking for signals of a successful company — even if they don’t guarantee future success — investors can gravitate toward the best companies even in the face of considerable complexity.
2. Invest in businesses you understand
No. 1 above isn’t enough by itself. For proof of that, just ask bank investors. Macquarie Group Limited (ASX: MQG) for instance, appeared to be a solid-performing, high-quality bank based on its 2007 return on equity of over 22%. But then… well, we all know how that has played out.
(As a clue, Macquarie’s share price hit a high of over $97 in 2007. It’s currently trading around $25.)
Many investors may have understood the risks that they were running by investing in a bank with a high proportion of its income from its so-called satellite funds and corporate transactions. However, some may have been caught completely by surprise as they assumed that the outward performance measures told the entire story.
So while you may not be able to fully unpack the complexity of a given company, it’s imperative that you have enough of an understanding to know what you don’t know and appreciate the risks you’re taking.
3. Accept uncertainty
The first step to combating a problem is admitting that you have one, right? Well, if you’re going to be an investor, you better get comfortable with the fact that there’s always uncertainty. Always.
Uncertainty means that unexpected, bad things can happen to good companies. And because we’re talking about predicting the future here, even when there’s nothing wildly unexpected, sometimes investors are just plain wrong.
The old saw “Don’t put all of your eggs in one basket” not only suggests that you have multiple baskets, but it also assumes that you have multiple eggs. An investor who’s accepted uncertainty and wants to safeguard his or her retirement collects a bunch of eggs from a bunch of different birds and divvies them up into multiple baskets, combining stocks,bonds, real estate, commodities, and cash.
For stocks in particular, that could mean finding multiple attractive individual stocks, or going with Exchange Traded Index Trackers such as State Street Global Advisors’ SPDR S&P/ASX200 Fund (ASX: STW), which seeks to closely match the returns of the S&P / ASX 200 Index (Index: ^AXJO) (ASX: XJO).
4. Use time arbitrage
That is, buying when short-term concerns are weighing down the stock and profiting by hanging on for the long term.
This is a great strategy for not only dealing with, but profiting from, uncertainty. BHP Billiton Limited (ASX: BHP) is a global resources company with significant exposure to China — which is more than enough to create significant near-term uncertainty. But for investors that are looking at BHP as a long-term bet, the stock currently has a dividend yield of more than 3% and an earnings yield (the inverse of the price-to-earnings ratio) of more than 13%.
In other words, having a long time horizon can help investors not only deal with uncertainty, but profit from it.
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Motley Fool contributor Mike King owns shares in BHP Billiton. The Motley Fool‘s purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.
A version of this article, written by Matt Koppenheffer, originally appeared on fool.com
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