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CHAPTER 6

HUMILITY IS THE GATEWAY TO ATTAINING WISDOM

Acknowledging what you don’t know is the dawning of wisdom.

—Charlie Munger

According to Confucius, real knowledge is knowing the extent of one’s ignorance, and this sentiment has been expressed by many philosophers, in one form or another. Socrates, for example, put it quite bluntly when he said, “The only true wisdom is in knowing you know nothing.” Only if we approach learning with an open mind can we truly educate ourselves.

The wiser we become, the more we realize how little we know. A lesser-known (and one of my all-time favorite) equation from Albert Einstein rings true: “Ego = 1 / Knowledge. More the knowledge lesser the ego, lesser the knowledge more the ego.” The deeper one dives into any field, the more humble one generally becomes (also known as the Dunning-Kruger effect). By demonstrating intellectual humility and acknowledging what we don’t know, we place ourselves into a beneficial position to learn more—thus, the dawning of wisdom. True expert knowledge in life and investing does not exist, only varying degrees of ignorance. This is not a problem to solve; it is simply how the world works. We cannot know everything, but we can work hard to become just about smart enough to make above-average decisions over time. That is the key to successful compounding. Ralph Waldo Emerson said, “Every man I meet is my master in some point, and in that I learn of him.” Learning and accepting help from others creates value far beyond our individual capabilities. Look at every interaction as an opportunity to learn from the people you meet. You will be amazed at how quickly you grow and how much better you become, both as a professional and, more important, as a human being. A tree that wants to touch the sky must extend its roots into the earth. The more it wants to rise upward, the more it has to grow downward. Similarly, to rise in life, we need to be down to earth and humble.

I was born not knowing and have had only a little time to change that here and there.

—Richard Feynman

Always question what you think you know, and remember that every subject probably is more complex than we currently recognize. Such self-awareness creates a more accurate mental map of reality, which in turn results in adopting language that more closely reflects the nuances of the world. This is particularly true when we encounter absolutist words—such as “never” instead of “seldom,” “all” instead of “many,” and “always” instead of “usually” (even “etc.” is a powerful reminder that we are leaving things out). A simple but effective way to remain self-aware is to add phrases like “seems to me” or “so far as I know” to these types of assertions.

You get the idea. We never can be fully sure.

Humility Is the Essence of Life

People couldn’t believe that I suddenly made myself a subordinate partner to Warren. But there are people that it’s okay to be a subordinate partner to. I didn’t have the kind of ego that prevented it. There always are people who will be better at something than you are. You have to learn to be a follower before you become a leader. People should learn to play all roles.

—Charlie Munger

The more you reach out to and associate with individuals (whether younger or older) who are better and smarter than you are, the more you will learn and the faster you will improve. Humility is the gateway to attaining wisdom.

Humility. The constant desire to learn so that you can overcome ignorance. Open-mindedness to listen to what makes you uncomfortable. Humility—or lack of it—is reflected through your actions. Not asking. Not learning from others. All because you think you already know. Truly humble people do not experience any uneasy feelings when someone younger but more successful or knowledgeable than them shares advice. If you’re truly happy and satisfied with the life you’re leading, you’ll be happy to see other people succeed. Don’t make this life all about you. Be happy when other people are doing well and encourage their success. When you support others, it shows that you’re not threatened by them because you are confident in your abilities.

Frank Wells was president of the Walt Disney Company from 1984 until his death in 1994. After Wells died, his son found a little piece of paper in his wallet that read “Humility is the essence of life.” Later, it was discovered that Frank Wells had carried that note with him for thirty years.

We Never Can Be Fully Sure

Doubt is not a pleasant condition, but certainty is absurd.

—Voltaire

The quality of our lives is the sum of decision quality plus luck. We look to learn from the results of our decisions to improve. Our lives, however, are too short to collect enough data from our experiences to evaluate the quality of our decisions from the small set of results we experience.

We can only do so much to answer questions on our own. We are only exposed to the information we encounter, only live the experiences limited to our personal lives, and only think of the hypothesis that we can conceive of. As a result, it can be hard to know what reasons someone else could have for believing something different. The best cure for overconfidence in your beliefs is to constantly remind yourself that you have experienced less than a tiny fraction of a percent of what has happened in the world. This experience, however, ends up representing nearly 100 percent of how you believe the world works. People tend to believe in what they have personally seen, far more than what they read has happened to others. We are all biased by our personal history. Our installed beliefs are the result of our personal experiences in the past, and they shape our visual prism. If you have lived through hyperinflation or a severe bear market or were born in a poor family or have been discriminated against, you already believe in something that people who have not experienced those things never will. You likely also grossly overestimate the chance of those events happening again. Morgan Housel offers a helpful suggestion to help us better empathize: “Start with the assumption that everyone is innocently out of touch and you’ll be more likely to explore what’s going on through multiple points of view, instead of cramming what’s going on into the framework of your own experiences. It’s hard to do. It’s uncomfortable when you do. But it’s the only way to get closer to figuring out why people behave like they do.”¹

Becoming Rich Versus Staying Rich

Many people achieve success, but to sustain the same (and potentially build on it) over an entire lifetime requires humility, gratitude, and a constant learning mind-set. Becoming rich often becomes the biggest obstacle to staying rich. Winning big makes many of us feel invincible, and that feeling entices us to bet big on what worked for us in the recent past. This ends up creating a catastrophic event when the world changes or luck turns against us. Housel writes:

It goes like this. The more successful you are at something, the more convinced you become that you’re doing it right. The more convinced you are that you’re doing it right, the less open you are to change. The less open you are to change, the more likely you are to tripping in a world that changes all the time.

There are a million ways to get rich. But there’s only one way to stay rich: Humility, often to the point of paranoia. The irony is that few things squash humility like getting rich in the first place.

It’s why the composition of Dow Jones companies changes so much over time, and why the Forbes list of billionaires has 60 percent turnover per decade….

Humility doesn’t mean taking fewer risks. Sequoia takes as big of risks today as it did 30 years ago. But it’s taken risks in new industries, with new approaches, and new partners, cognizant that what worked yesterday isn’t what will work tomorrow.²

Absolute certainty never exists in the world of finance. Yet, on Wall Street, overconfidence is all-pervasive. Jason Zweig highlights the hubris of investors in his definitions of certainty and uncertainty in his book The Devil’s Financial Dictionary:

CERTAINTY. An imaginary state of clarity and predictability in economic and geopolitical affairs that all investors say is indispensable—even though it doesn’t exist, never has, and never will. The most fundamental attribute of financial markets is uncertainty.

UNCERTAINTY. The most fundamental fact about human life and economic activity. In the real world, uncertainty is ubiquitous; on Wall Street, it is nonexistent.³

Contrast the kind of egotism found on Wall Street with the humility of one of the greatest minds outside of finance, Richard Feynman. We should all learn from this great teacher, who humbly admits that nothing is ever certain: “We know that all our statements are approximate statements with different degrees of certainty; that when a statement is made, the question is not whether it is true or false but rather how likely it is to be true or false.”⁴

Investing is no different. Approximate statements and different degrees of certainty require us to think probabilistically. The question is not “Will I be right or will I be wrong?” The question should be “What is the probability of this scenario versus another, and how does this information affect my assessment of value?” We must always leave room for doubt, even in those ideas that hold our highest conviction. Otherwise, we risk becoming complacent.

An attitude of knowing everything makes it difficult to learn anything. According to Feynman, before you begin any task, you first must not know the answer. We must begin by being uncertain about the answer. Otherwise, how can we learn? This may sound like common sense, but it is not so common in the world of finance.

Acknowledging that we do not know something is much more beneficial than having the incorrect answers. If we can be certain of one thing, it is that we can never be fully sure. We must learn to live with doubt and embrace uncertainty. We shouldn’t feel anxious about not knowing things. Rather, we should welcome it. Because the realization of not knowing something is an opportunity to learn. In science, “I don’t know” is not an indication of a failure but rather is a necessary first step toward enlightenment. As Feynman puts it,

The question of doubt and uncertainty is what is necessary to begin; for if you already know the answer there is no need to gather any evidence about it.

I have approximate answers and possible beliefs and different degrees of certainty about different things, but I’m not absolutely sure of anything and there are many things I don’t know anything about.

The first source of difficulty is that it is imperative in science to doubt; it is absolutely necessary, for progress in science, to have uncertainty as a fundamental part of your inner nature. To make progress in understanding, we must remain modest and allow that we do not know. Nothing is certain or proved beyond all doubt. You investigate for curiosity, because it is unknown, not because you know the answer. And as you develop more information in the sciences, it is not that you are finding out the truth, but that you are finding out that this or that is more or less likely.

There are few absolute truths in investing. The best we can do is gather evidence as diligently as possible to assess the likelihood of various outcomes. We do this by connecting various pieces of the puzzle and trying to put them together in a way that makes sense. We are constantly exploring. We are constantly looking for new evidence—trying to find out more about what we know and to better understand what we don’t know.

After we gather the evidence, we must study the same. What did we learn? What does that imply for our original hypothesis? How likely is it that we are correct? Are there other factors we failed to consider that may have led to different results or conclusions? Investors are often too anxious to jump to conclusions that support their original thinking. Confirmation bias is difficult to resist. Again, we should learn from Feynman:

If we investigate further, we find that the statements of science are not of what is true and what is not true, but statements of what is known to different degrees of certainty: “It is very much more likely that so and so is true than that it is not true”; or “such and such is almost certain but there is still a little bit of doubt”; or, at the other extreme, “well, we really don’t know.” Every one of the concepts of science is on a scale graduated somewhere between, but at neither end of, absolute falsity or absolute truth. It is of great value to acknowledge ignorance.

Investors have a difficult time acknowledging the presence of uncertainty. But uncertainty remains the most fundamental attribute of financial markets. Living in an imaginary world of certainty can lead to potentially fatal mistakes in the real world of finance. The sooner we accept that we live in an uncertain world—that we don’t have all the answers—the sooner we can begin trying to become wiser. This understanding is vital. Once accepted, it shapes our worldview and becomes a natural way of thinking. Incorporating uncertainty in the way we think about what we believe creates open-mindedness to alternative hypotheses, moving us closer to a more objective stance toward information that does not align with what we believe—that is truth seeking.

With respect to investing, intellectual humility is best illustrated through the concept of the circle of competence.

The Circle of Competence

I’m no genius, but I’m smart in spots, and I stay around those spots.

—Tom Watson Sr.

Warren Buffett has always advised investors to focus on operating only in areas they understand best. In HBO’s documentary Becoming Warren Buffett, he compared his investing strategy to America’s favorite pastime, referencing baseball legend Ted Williams’s book The Science of Hitting, in which the all-star slugger emphasized the importance of knowing your sweet spot: “If he waited for the pitch that was really in his sweet spot, he would bat .400. If he had to swing at something on the lower corner, he would probably bat .235.”⁵

The lesson for investors, Buffett says, is that we don’t have to swing at every pitch: “The trick in investing is just to sit there and watch pitch after pitch go by and wait for the one right in your sweet spot. And if people are yelling, ‘Swing, you bum!’ ignore them.”

Just as Williams only swung at pitches in his sweet spot, Buffett only invests in companies that are within his “circle of competence,” a concept he described for the first time in his 1996 letter to shareholders: “What an investor needs is the ability to correctly evaluate selected businesses. Note that word ‘selected’: You don’t have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital [emphasis added].”⁶

This means that, as investors, we need to restrict ourselves only to those businesses whose long-term economics we can understand. For most investors, investing outside one’s circle of competence is what often leads to big losses. One should not blindly chase “buzzing stocks” or get swayed by exciting “stories,” “narratives,” or “futuristic” concepts, because these kinds of businesses usually have unproven track records or they lack profitability and cash flow.

The key idea behind the circle of competence is not its size—the absolute number of businesses you can understand—but your awareness about its size—the kind of businesses you know you can understand.

It is not important how big that circle is. What matters is how well you have defined its perimeter. Investors who are intellectually honest and humble are always willing to admit their limitations and to stay within their area of expertise.

So, how do you find your circle of competence?

Instead of picking what you know, use the inversion technique, popularized by Charlie Munger, to create your circle of competence. Inspired by the German mathematician Carl Gustav Jacob Jacobi, Munger explains,

Invert, always invert: Turn a situation or problem upside down. Look at it backward. What happens if all our plans go wrong? Where don’t we want to go, and how do you get there? Instead of looking for success, make a list of how to fail instead—through sloth, envy, resentment, self-pity, entitlement, all the mental habits of self-defeat. Avoid these qualities and you will succeed. Tell me where I’m going to die, that is, so I don’t go there.⁷

Try to know the things you don’t know, and then draw a circle that keeps those things out. (This is very much what scientists do. They approach a problem and its solution by trying to prove it is false, not that it is true.)

In investing, risk comes from not knowing what you are doing. In fact, Buffett considers this to be one of the biggest risks in investing. So much so that he avoids using equity risk premiums to value stocks, confining himself only to those situations about which he is highly certain. Buffett uses the interest rate of long-term U.S. Treasury bonds to value stocks, except when he believes it is artificially low. During those times, he adds a few percentage points to his discount rate. He says, “I put a heavy weight on certainty. If you do that, the whole idea of a risk factor doesn’t make sense to me. Risk comes from not knowing what you’re doing.” In a similar vein, Buffett adds, “We don’t discount the future cash flows at 9 percent or 10 percent; we use the U.S. Treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”⁸

At the 1998 Berkshire annual meeting, Buffett explained how he thinks about risk when evaluating any business:

When we look at the future of businesses, we look at riskiness as being sort of a go/no-go valve. In other words, if we think that we simply don’t know what’s going to happen in the future, that doesn’t mean it’s risky for everyone. It means we don’t know—that it’s risky for us. It may not be risky for someone else who understands the business. However, in that case, we just give up. We don’t try to predict those things. We don’t say, “Well, we don’t know what’s going to happen. Therefore, we’ll discount some cash flows that we don’t even know at 9 percent instead of 7 percent.” That is not our way to approach it.⁹

How does such strict adherence to his circle of competence greatly help Buffett in investing? He explains: “If we have a business about which we’re extremely confident as to the business results, we’d prefer that its stock have high volatility. We’ll make more money in a business where we know what the end game will be if it bounces around a lot.”¹⁰

If you know things you don’t know—your circle of incompetence—you will automatically get to what you do know—your circle of competence. Once you have defined your circle of incompetence, draw your personal circle, just as Buffett did. Buffett’s investing process involves creating three lists of companies—in (simple and easy-to-understand businesses), out (difficult to understand), and too hard (so complex that it is not worth devoting any time to understanding them). Buffett once said that 99 percent of the stock ideas that came to him fell into the too hard category.

Just think about that for a minute. In Buffett, we have arguably the greatest investor who has ever lived admitting that he does not understand 99 percent of the businesses he comes across. The next time you feel you know it all, reflect deeply on that fact. A genuine and honest adherence to one’s circle of competence is a deeply humbling experience. Let me share a personal example, to illustrate. In January 2018, I came across the most recent edition of Indian Economy & Market magazine, which contained investment thesis reports on “75 Hidden Gems,” many of which had been written by my respected seniors and peers. I could properly understand only one name out of seventy-five. This is perfectly acceptable. Remember, it is not a competency if you don’t know the edge of it. Venturing outside these edges is what gets investors into big trouble.

Warren and I know better than most people what we know and what we don’t know. That’s even better than having a lot of extra IQ points. People chronically misappraise the limits of their own knowledge; that’s one of the most basic parts of human nature. Knowing the edge of your circle of competence is one of the most difficult things for a human being to do. Knowing what you don’t know is much more useful in life and business than being brilliant [emphasis added].

—Charlie Munger

One sign of emotional intelligence is the ability to admit error. A mistake denied is a lesson not learned. Reflect deeply and objectively evaluate your performance. It is only through an honest self-assessment that an investor can discover his or her circle of competence. A key benefit of emotional intelligence is the intellectual honesty to view the world as it really is, not as one wants it to be, hopes it to be, or wishes it to be. My investing strike rate improved significantly once I acknowledged what I do not know and stayed within my circle of competence.

The basic idea behind the circle of competence is so simple it is embarrassing to say it out loud: when you are unsure and doubtful about what you want to do, do not do it.

If you can’t find businesses within your circle of competence, don’t hurriedly step outside that circle because of the fear of missing out, which is often the case in a bull market. Instead, spend time studying industries and companies outside your circle before crossing the boundaries. The biggest advantage of developing one’s circle of competence over time is that different industries and types of companies are in favor at different stages of the market cycle. Having an expanded opportunity set at one’s disposal to choose from can prove to be highly profitable at such times.

Again, it’s not important how big your circle of competence is. What is critical is to clearly know where the edges are.

It’s not a competency if you don’t know the edge of it.

—Charlie Munger

Now you may well ask, “But how do I expand those edges so that I can enlarge my circle of competence?” There is a simple way to do it.

It’s simple but not easy.

Read. A lot. That is the only way you can expand your circle of competence.

For example, read a book called Analyzing and Investing in Community Bank Stocks and then read the annual reports of a few community banks. These are relatively easier to understand and value. Or pick an industry in which you have some expertise and begin reading the annual reports of the companies in that industry.

I learned early in my career that if you read the annual reports, you’ve done more than 90 percent of the people on Wall Street. If you read the notes to the annual report, you’ve done more than 95 percent of the people on Wall Street.

—Jim Rogers

In investing, the person that turns over the most rocks wins the game. There is no alternative to hard work. In life, relationships, business, or investing, nothing will work unless you do. And there is no intelligent reason for an investor to settle for an inferior track record in a marketplace filled with companies with outstanding fundamentals.

I’ve always said that if you look at ten companies you’ll find one that’s interesting. If you look at 20, you’ll find, two; if you look at 100, you’ll find ten. The person that turns over the most rocks wins the game…. It’s about keeping an open mind and doing a lot of work. The more industries you look at, the more companies you look at, the more opportunity you have of finding something that’s mispriced [emphasis added].

—Peter Lynch

Buffett once remarked:

Back in 1951 Moody’s published thick handbooks by industry of every stock in circulation. I went through all of them, thousands of pages, motivated by the hope that a great idea was just on the next page. I found companies like National American Insurance and Western Insurance Securities Company that nobody was paying attention to that were trading for far less than their intrinsic values. Last year we found a steel company on the Korean Stock Exchange that had no analyst coverage, no research, but was the most profitable steel company in the world.¹¹

Buffett’s story reminds me of a few of my experiences. Every day, I diligently review all of the corporate announcements on the Bombay Stock Exchange (BSE) website. It is a painstaking exercise for many, but for me, it is like an intellectual treasure hunt wherein I may strike gold at any time. Every day, I create numerous opportunities for serendipity to find me.

My personal investment opportunity set has significantly expanded over the years, with time and experience in the markets. Initially, it was restricted only to secular growth stocks at reasonable to expensive valuations. But now it covers multiple areas of the investment universe, including commodities, cyclicals, deep value, and spinoffs, as well as loss-making companies that are turning around, as reflected in slow, gradual changes (low contrast) in their improving balance sheet, working capital, margins, or a significant positive change in their industry dynamics. Instead of being restricted by my personal, biased views to a small opportunity set, as was the case during my early years, I am now able to invest in a variety of industries and situations, wherever I find mispricing of value and a highly favorable risk-and-return trade-off.

Markets continually change. It also reminds me to look for investment opportunities in different markets, rather than keep going back to a well that is dry.

—Robert Kiyosaki

No single strategy works all of the time and in every kind of market. That’s why it’s essential to build up one’s investing arsenal to be able to hunt for value from within different areas.

Over the years, I have come to realize and appreciate just why this is critically important: a bull market is always going on, at all times, in some specific sectors of the stock market. For instance, even during the 2009–2013 bear market in India, consumer discretionary, pharmaceutical, and information technology companies created a lot of wealth for investors. New trends always emerge during a bear market—that’s the period during which most investors are either waiting for their purchase price or are busy committing fresh sins by averaging the winning leader stocks bought during the previous bull market. (The number of retail investors in a sector tends to go up during its bullish phase, so, during the subsequent bear market for the sector, relentless selling usually occurs at every higher level, as old investors try their best to exit and rid themselves of bad memories.)

Where should we devote our limited time in life to achieve maximum success? Munger gives us the answer: “You have to figure out what your own aptitudes are. If you play games where other people have the aptitudes and you don’t, you’re going to lose. And that’s as close to certain as any prediction that you can make. You have to figure out where you’ve got an edge. And you’ve got to play within your own circle of competence.”¹²

The takeaway from Buffett and Munger is clear. If you want to improve your odds of success in life, business, and investing, then clearly define the perimeter of your circle of competence and operate only inside it. Over time, work to expand that circle, but never fool yourself about its current boundaries. As Feynman says, “The first principle is that you must not fool yourself—and you are the easiest person to fool.”

The following hypothetical conversation captures the essence of the dawning of wisdom.

Philosopher: What are the three wisest words in investing?

Value investor: “Margin of safety.”

Philosopher: Wrong.

Value Investor: Then…?

Philosopher: “I don’t know.”