Think Like a Scientist

Yesterday I recommended that investors employ the scientific method even though investing is the last liberal art.  That may sound like a contradiction, but it isn’t.

scienceThe Oxford English Dictionary defines the scientific method as “a method or procedure that has characterized natural science since the 17th century, consisting in systematic observation, measurement, and experiment, and the formulation, testing, and modification of hypotheses.”  What it means is that we observe and investigate the world and build our knowledge base based upon what we learn and discover, but we check our work at every point and keep checking our work.  It is inherently experimental.  In order to be scientific, then, our inquiries and conclusions need to be based upon empirical, measurable evidence. 

Thus the scientific method can and should be applied to traditional science as well as to all types of inquiry and study — including investing. The great scientist Richard Feynman even applied such experimentation to hitting on women. To his surprise, he learned that he (at least) was more successful by being aloof than by being polite or by buying a woman he found attractive a drink.This approach to figuring out what has gone on, is going on, and will go on as a matter of objective fact — the essence of the scientific method — is demonstrated in the film “And the Band Played On” (about 22 minutes in – see the video below).  In that scene, researchers at the Centers for Disease Control meet in 1981 to discuss the statistics of a deadly virus — that we later learn to be AIDS — sweeping through the gay community. To that point, nobody had been able to come up with a decent explanation for what they had been observing. So the boss walks into the meeting and asks, “All right, what do we think? What do we know? What can we prove?”

That concept ends up being a running theme in the movie and gets to the heart of the scientific endeavor. What do we think? What do we know? What can we prove?

These categories can be bit loose, of course, with distinctions based upon the nature and quality of the evidence.  Moreover, scientific proof isn’t necessarily certain, as it can be in math.  We could still be wrong, at least in theory, but we’re really, really sure and can demonstrate why — factually. Even so, there are relatively few things in the investment world that I am confident I can prove.  Among these are the existence and persistence of the size premium (after critical mass is achieved, smaller wins), costs matter a lot, and that we are slaves to our cognitive and behavioral biases.

In this context, then, “know” is less sure or, (more likely) really sure but where we don’t have all the data we’d like to support it. As in the movie, “I can’t prove that the sun isn’t going to turn into a bran muffin next Tuesday, but after 20 years of doing this I know what I know.” This category includes the existence and persistence of the value premium, momentum and low beta outperformance persistence, the efficient market hypothesis being nonsense (even though it is exceedingly difficult to beat the market) and the reality that good advice matters a lot.

Stuff in the “think” category are things I believe to be true but am not entirely sure of.  These include the idea that mixing passive and active strategies makes great sense, that “old always” (mean reversion) beats “new normal,” and that the universe of advisors is poorly trained, poorly incentivized, and ill-equipped.

I would be interested in the lists of others, so long as the lists express evidence-based conclusions rather than ideological commitments.  Let’s do science — not tell tales.


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