At the 1998 shareholder meeting for Berkshire Hathaway, Warren Buffett said: “We try to think about two things: things that are important and things that are knowable.” Although at first glance this comment can seem quite innocuous, it is an essential idea to understand if we are to successfully navigate the uncertainty and noise of financial markets. Investors are generally quite poor at defining what matters to them and why; and this is a problem which causes all sorts of decision-making challenges. There is, however, a quick way to get better at this – a crystal ball test. 

Before describing the test, let’s reflect on what Buffett is getting at here. He is saying that for his investment approach there are only a select number of elements that will influence results over time and an even smaller number of this group that are knowable (or predictable) to any reasonable extent. That is where his focus is.

Of course, nothing is perfectly knowable, but there are some things that we can have a sufficient level of confidence in, and many others that are, if not random, pretty close to it. The are far more things in the latter group than the former and distinguishing between them is vital.

Before worrying about whether something is knowable, we need to define which factors we believe are important to the success of our investment. How do we do that? Let’s turn to the crystal ball.

We can ask ourselves, and other investors, this question:

“If you had a crystal ball and could see one piece of information in the future that would materially influence this investment view, what would it be?”

We can apply this question to any type of investment – whether it be about an individual stock, or a major asset allocation shift. It should quickly elicit what we think the most important factors are, and then we can judge if there is any chance of us predicting it without the aid of a crystal ball.

Let’s take an example. If I had to take a view on the performance of ten year treasuries over the next five years, what would I want to foresee using the crystal ball? It would be US inflation in five years’ time.

This tells you that – for me – inflation is the most important variable in determining the returns of ten year treasuries over the next five years. Unfortunately, I have no idea what the rate of inflation will be, which obviously will impact how much conviction I would ever take in a view on US treasuries.

We can also invert the crystal ball question to get to a similar answer by asking:

“If you knew the outcome of X in advance, how would it impact your decision?”

If I knew the rate of inflation in the US would be 6% in five years’ time, it would almost certainly influence my view on US treasuries.

This type of question can help us cut short situations where people are debating some financial market issue that is not only unknowable but, even if we could predict it, we wouldn’t know what to do about it. (Elections are the gift that keeps on giving in this regard).

Using Buffett’s important and knowable framing, we can think about the usefulness of a crystal ball in three different ways:

– Something is both important and knowable: A crystal ball might help a little, but not much because we are reasonably confident in the variable anyway. (Think here of things like long-run earnings growth or starting valuations).

–  Something is important and not knowable: A crystal ball is absolutely vital because something matters but we cannot anticipate it.

– Something is not important and not knowable: We can use the crystal ball as a paperweight because even seeing the future is of no use to us.  

Unfortunately, investors are prone to spending far too much time in the latter two groups. Either making decisions that are heavily influenced by variables that are inherently unknowable, or wasting time on things that wouldn’t be useful even if they were knowable (which they aren’t).  

The crystal ball test can be an exceptionally useful means of better understanding what type of investor we and others are. It is particularly effective in gauging what an investors’ true time horizon is (the factors that matter change with our horizon) and what variables are foremost in our thinking.

It is also a great sense check to stop ourselves spending an inordinate amount of time on financial market issues just because they are at the front of everyone’s mind, not because they are consequential.

How best can we incorporate Buffett’s thinking on focusing on what’s important and what is knowable into practice? I think there are seven key aspects. We should:

1) Be clear about the variables that are important to the success of our investment decision. 

2) Understand whether these are sufficiently knowable / predictable.

3) Focus on elements that are both important and knowable.

4) Be aware of things that are important to our view but inherently unknowable.

5) Avoid high conviction investment views that are heavily reliant on unknowable variables.

6) Use diversification to protect against important but unknowable factors.

7) Stop worrying about things that are neither important nor knowable.  

Investors are best served by adopting an approach where the most important determinants of success are also at least somewhat knowable. If we need a crystal ball for good outcomes, I don’t like our chances.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).