Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 73

Learn your knowns and unknowns

Investing is a ‘risky’ business. Whenever you part with capital, you’re doing so in the hope that the return will adequately compensate you for the likelihood of loss. As such, one of the keys to long run success with any investment is an intimate understanding of both risk and reward.

Unfortunately, it seems that people are more familiar with the expected returns of an investment, and less aware of the risks required to generate those returns. This is akin to investing with a blindfold on. For instance, many investors will be familiar with a company’s dividend yield as distributions are a primary source of their income. But they may fail to consider that their income can be adversely affected by a drop in the share price if they sell.

Assessing different possible outcomes

This imbalance may be explained by the inherent difficulty of quantifying risk in the share market. To accurately assess risk, you need to understand the payoffs from all possible outcomes. For instance, when you enter a casino and walk up to a roulette table, there are three possible outcomes from putting your chips on black. If the ball lands on red or zero, then you lose all your capital. If the ball lands on black, then the payout is twice the initial wager.

Defining the risks and rewards in the share market is far more intensive. It’s vital to understand intimate details of a company’s operations and all external forces that may impact earnings.

Of course, there are natural constraints to the amount of time, effort and resources one can commit to research. What’s more, if you attempt to understand every minor aspect of a company, you may become lost in the detail and fail to see the bigger picture.

Clearly there will be a point where you will have a sufficient, but incomplete amount of knowledge to justify your commitment to an investment. But how long should you spend researching a company?

Unfortunately, there is no clear answer this question. What may be helpful though is to consider Donald Rumsfeld’s simple (yet rather ineloquent) approach to assessing risk. The former US Secretary of State divides risk into three categories – known knowns (things that we know that we know), known unknowns (things that we know that we do not know), and unknown unknowns (things that we don’t know we don’t know).

You may need to re-read that passage again before continuing. Although it’s a complete tongue-twister, we can actually apply this into a research framework.

What we know and what we don't know

The easiest place to begin researching a business is to consider the known knowns. What do we know about long-term performance? Has the business been successful in the past, or is it just another promising story?

A deep pool of academic research has shown that companies that have generated meaningful returns over a long period have certain financial characteristics. For instance, companies with a track record of high returns on equity and strong balance sheets should offer more compelling long-term value than companies with highly volatile performance and excessive borrowings.

Understanding a company’s financial statements will help shape your subsequent research, as it will allow you to become aware of certain unknowns that warrant investigation.

A critical known unknown is how the business operates, yet many investors would dismiss this as a known known. For instance, you may think you know how Woolworths operates, because you buy your groceries there. But can you clearly articulate how one dollar of revenue flows through the business? The more you understand how a business operates, the more unknowns you will become aware of, which further improves your understanding of the investment’s risk.

Your analysis should continue until you’re comfortable for the known unknowns to remain unknown. For instance, the customer base of a business is a critical known unknown. If your research reveals that a company is dependent on a single customer, this presents a material unknown that requires further investigation. But if the customer base is highly fragmented, then it may not be worthwhile (or even possible) to identify the risks in every contract.

Invariably there will always be unknown unknowns when investing. The weather, global events, human behaviour and emotions can have a meaningful impact on a company’s prospects, but these are more difficult to quantify.

It is because of this unquantifiable risk that we should require a sufficient margin of safety to warrant the investment. If we remain patient and wait for the share price to trade at a meaningful discount to what we think the business is worth, then this gives us an additional buffer against adverse events that we’ve yet to consider.

Of course, your analysis of a company won’t stop once capital is committed. Over time, you will become aware of more unknowns, and these revelations may result in a completely different investment thesis. While your investment style may become more conservative with this approach, your portfolio is more likely to generate returns that better reflect the effort applied to understanding the risks.

 

Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’.

 

  •   31 July 2014
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

A tonic for turbulent times: my nine tips for investing

What makes a company attractive?

Quality over quantity: a lesson of value

banner

Most viewed in recent weeks

The growing debt burden of retiring Australians

More Australians are retiring with larger mortgages and less super. This paper explores how unlocking housing wealth can help ease the nation’s growing retirement cashflow crunch.

Four best-ever charts for every adviser and investor

In any year since 1875, if you'd invested in the ASX, turned away and come back eight years later, your average return would be 120% with no negative periods. It's just one of the must-have stats that all investors should know.

LICs vs ETFs – which perform best?

With investor sentiment shifting and ETFs surging ahead, we pit Australia’s biggest LICs against their ETF rivals to see which delivers better returns over the short and long term. The results are revealing.

Family trusts: Are they still worth it?

Family trusts remain a core structure for wealth management, but rising ATO scrutiny and complex compliance raise questions about their ongoing value. Are the benefits still worth the administrative burden?

13 ways to save money on your tax - legally

Thoughtful tax planning is a cornerstone of successful investing. This highlights 13 legal ways that you can reduce tax, preserve capital, and enhance long-term wealth across super, property, and shares.

Warren Buffett's final lesson

I’ve long seen Buffett as a flawed genius: a great investor though a man with shortcomings. With his final letter to Berkshire shareholders, I reflect on how my views of Buffett have changed and the legacy he leaves.

Latest Updates

Retirement

Why it’s time to ditch the retirement journey

Retirement isn’t a clean financial arc. Income shocks, health costs and family pressures hit at random, exposing the limits of age-based planning and the myth of a predictable “retirement journey".

Financial planning

How much does it really cost to raise a child?

With fertility rates at a record low, many say young people aren’t having kids because they’re too expensive. Turns out, it’s not that simple and there are likely other factors at play.

Exchange traded products

Passive ETF investors may be in for a rude shock

Passive ETFs have become wildly popular just as markets, especially the US, reach extreme valuations. For long-term investors, these ETFs make sense, though if you're investing in them to chase performance, look out below.

Shares

Bank reporting season scorecard November 2025

The Big Four banks shrugged off doomsayers with their recent results, posting low loan losses, solid margins, and rising dividends. It underscores their resilience, but lofty valuations mean it’s time to be selective. 

Investment strategies

The real winners from the AI rush

AI is booming, but like the 19th-century gold rush, the real profits may go to those supplying the tools and energy, not the companies at the centre of the rush.

Economy

Why economic forecasts are rarely right (but we still need them)

Economic experts, including the RBA, get plenty of forecasts wrong, but that doesn't make such forecasts worthless. The key isn't to predict perfectly – it's to understand the range of possibilities and plan accordingly.

Strategy

13 reflections on wealth and philanthropy

Wealth keeps growing, yet few ask “how much is enough?” or what their kids truly need. After 23 years in philanthropy, I’ve seen how unexamined wealth can limit impact, and why Australia needs a stronger giving culture.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.