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

Australian stocks will crush housing over the next decade, 2025 edition

Two years ago, I wrote an article suggesting that the odds favoured ASX shares easily outperforming residential property over the next decade. Here’s an update on where things stand today.

Australia's retirement system works brilliantly for some - but not all

The superannuation system has succeeded brilliantly at what it was designed to do: accumulate wealth during working lives. The next challenge is meeting members’ diverse needs in retirement. 

Get set for a bumpy 2026

At this time last year, I forecast that 2025 would likely be a positive year given strong economic prospects and disinflation. The outlook for this year is less clear cut and here is what investors should do.

Meg on SMSFs: First glimpse of revised Division 296 tax

Treasury has released draft legislation for a new version of the controversial $3 million super tax. It's a significant improvement on the original proposal but there are some stings in the tail.

The 3 biggest residential property myths

I am a professional real estate investor who hears a lot of opinions rather than facts from so-called experts on the topic of property. Here are the largest myths when it comes to Australia’s biggest asset class.

Property versus shares - a practical guide for investors

I’ve been comparing property and shares for decades and while both have their place, the differences are stark. When tax, costs, and liquidity are weighed, property looks less compelling than its reputation suggests.

Latest Updates

Investment strategies

Building a lazy ETF portfolio in 2026

What are the best ways to build a simple portfolio from scratch? I’ve addressed this issue before but think it’s worth revisiting given markets and the world have since changed, throwing up new challenges and things to consider.

Investment strategies

21 reasons we’re nearing the end of a secular bull market

Nearly all the indicators an investor would look for suggest that this secular bull market is approaching its end. My models forecast that the US is set for 0% annual returns over the next decade.

Property

13 million spare bedrooms: Rethinking Australia’s housing shortfall

We don’t have a housing shortage; we have housing misallocation. This explores why so many bedrooms go unused, what’s been tried before, and five things to unlock housing capacity – no new building required.

Investment strategies

Market entry – dip your toe or jump in all at once?

Lump sum investing usually wins, but it can hurt if markets fall. Using 50 years of Australian data, we reveal when staging your entry protects you, and when it drags on returns. 

Investment strategies

The US$21 trillion question: is AI an opportunity or excess?

It has been years since the US stock market has been so focused on a single driving theme, and AI is unquestionably that theme. This explores what it means for US and global markets in 2026.

Economy

US energy strategy holds lessons for Australia

The US has elevated energy to a national security priority, tying cheap, reliable power to economic strength, AI leadership, and sovereignty. This analyses the new framework and its implications for Australia.

Strategy

Venezuela’s democratic roots are deeper than Trump knows

Most people know Maduro was a dictator and Venezuela has oil. Few grasp the depth of suffering or the country’s democratic history - essential context as the US ousts Maduro and charts Venezuela’s future. 

Sponsors

Alliances

© 2026 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.