As Harry Callahan once said -- a man's got to know his limitations.
"Go ahead, make my day" is one of the most famous lines in cinema history. So much so that back in 2005 the American Film Institute put it in sixth place in its list of the top 100 movie quotations. Just in case you don't know, the line was said by Clint Eastwood as he portrayed maverick San Francisco police inspector "Dirty Harry" in Sudden Impact (the fourth film in the Dirty Harry series; it is often mistakenly attributed to the first film, Dirty Harry).
Harry Callahan dispenses an incredibly useful piece of investment advice in the second Dirty Harry film, Magnum Force, where he counsels that "man's got to know his limitations." This is particularly good guidance for newcomers to investing ("rookies" as Harry would call them, somewhat disparagingly).
Knowing your limitations, and learning to operate within them, is an excellent way to avoid making big mistakes. If you can't drive a motor car then you'd be stupid to drive a Formula One car at racing speeds on the M25. But it's easy to make an equally poor investment decision when you are working outside your limitations but don't acknowledge this fact. Recognising those investments where you lack sufficient expertise to analyse them, then avoiding these investments, is a good way to improve your investing skills and will hopefully save you a lot of money.
Dotcoms and Bubbles
Having a high degree of expertise in one field does not give you a similar level of expertise in a different field. That should be obvious, yet many people believe that this is the case. Witness the large number of Hollywood actors who repeatedly make idiots of themselves by assuming that their acting skill translates into expertise in science or politics.
Isaac Newton, arguably the greatest scientist of all time, showed that his understanding of the laws of nature did not easily transfer to investing when he lost a fortune in the South Sea Bubble, a period which included such scams as the infamous business which raised over £2,000 (a huge sum at that time) "…for carrying-on an undertaking of great advantage but no-one is to know what it is."
Let's revisit the dotcom boom. A fairly well-known maxim is "invest in what you know"; it comes from Peter Lynch and it is good advice. The problem for many people during the dotcom boom is that they thought that a good understanding of a company's products gave them an understanding of the firm's business and finances. So without knowing how the company actually made money, people gleefully ploughed fortunes into the likes of Pets.com and other disasters.
What let these investors down is that they ignored their limitations; they incorrectly assumed that their expert product knowledge gave them expert investment knowledge. This caused them to become extremely overconfident when it came to picking investments, particularly when they had a few early (lucky) successes thanks to the then prevailing mania. Pets.com got into trouble because it was selling its products at below cost which is a cast-iron recipe for losing money. You can have the greatest product in the world, yet if you're losing a dollar on every sale you're going to eventually run out of money.
Circle of Competence
When Warren Buffett buys shares in companies like Tesco (LSE: TSCO), GlaxoSmithKline (LSE: GSK) and Coca-Cola, it's only after he's understood both how the businesses make money and how the businesses will continue to make money. That's why Buffett avoids technology companies; not because he doesn't understand technology but because he cannot reasonably predict how the company will continue to make money in the future in a market where a competitor can spring up out of nowhere. Technology companies fall outside Buffett's "circle of competence", the name he gives to those simple and understandable businesses where he knows more than the average investor.
After you've been investing for a while you will acquire a reasonable amount of expertise in certain fields, but most importantly, you will know the fields in which you have insufficient expertise and hopefully have learnt to steer well clear of them. Buffett recommends staying within your circle of competence or to use low-cost tracker funds ("when dumb money acknowledges its limitations it ceases to be dumb").
Investor's Toolkit
It will greatly help you to learn how to read a balance sheet and a profit and loss account. You don't need to be an accountant, but you are putting yourself at a major disadvantage if you cannot read accounts, unless you have the expertise to be a trader. The more you learn, the wider your circle of competence and the easier it becomes to understand what you don't know.
A common way in which people come unstuck is by "overtrading" -- buying and selling investments far too frequently and finding that their costs erode any profits that they may have made (whilst increasing their losses). However, some investors can and do make money trading this way. The key to identifying a successful trader is that in the short run they might be lucky but in the long run a trader only succeeds because of their expertise. If you can quickly identify whether you are a trader or not that will save you a lot of money (sadly, too many people don't and trade themselves into oblivion using borrowed money).
Take Dirty Harry's advice, learn to recognise your limitations, or as Donald Rumsfeld put it, turn your "unknown unknowns" into your "known unknowns."
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> Tony owns shares in GlaxoSmithKline.
