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Rationalism vs. Empiricism in Securities Analysis

by Lobo Tiggre
Tuesday, December 27, 12:00pm, UTC, 2022

In The Adventures of Sherlock Holmes, Dr. Watson is always saying that Holmes’ conclusions are inescapable.

They rarely are. They’re usually inferences that could be wrong for many reasons. But the author doesn’t supply reasonable objections to the bungling police, or even Watson.

This makes it seem that if one could just be as clever and observant as Holmes, one could deduce hidden truths with equal ease.

Alas, if only it were so…

Stepping away from the world of fiction, the problem is that if any of the premises are incorrect, even a perfectly correct train of logic can lead to an incorrect conclusion.

In real life, most premises are judgment calls, not the indisputable facts Holmes pulls out of his hat in every adventure.

As programmers say: “Garbage in, garbage out.”

Compounding this problem is Scottish philosopher David Hume’s observation that: “Reason is … the slave of the passions.”

This is problematic because most people seek out and place greater importance on facts that support cherished views. Few will scrupulously attend to all available facts in pursuit of the truth—especially when that would invalidate some idea they are wedded to.

The most dangerous and difficult aspect of this problem is that it’s much easier for us to see it in others than in ourselves.

We laugh at people who, after years of dismissing clear evidence that it just ain’t so, still believe a Nigerian prince is going to give them $5 million for helping him get his fortune out of Africa. But when, for example, a company we own shares in fails repeatedly to deliver value for shareholders, many of us look for excuses to avoid liquidating our mistake. And when we begin to suspect that we’ve made a mistake, many of us dig our heels in, doubling down on self-destruction rather than cutting our losses.

We clearly see the speck in our brother’s eye while remaining completely oblivious of the plank in our own.

I am not, however, writing just to berate emotional investors.

Frankly, I think all of us make this mistake. The more successful ones among us just do it less often.

But how can we be vigilant against what we cannot see in ourselves?

Well, it is possible to cultivate an attitude of skepticism and to develop the discipline of applying it to our own positions as well as those of others. Self-examination is a choice anyone can make. It’s just that few do. That creates an advantage for those with the courage to make it their own practice.

This is a matter of personal psychology—not something I can help with much, beyond encouraging all to embrace the discipline. (It would make for an excellent new year’s resolution.)

There is, however, an external aspect of the issue that I can direct your attention to.

Beware of theories that explain everything—especially those that fit well with what we already believe.

Suppose, for example, that unscrupulous publishers want to make money selling newsletters to gold bugs. They know that most of their targets favor free markets and are suspicious of big government. The most effective way to drive sales is to propound a theory that something governments are doing is going to send gold prices through the roof.

Inflation is too slow and amorphous to whip the audience up to a frenzy. Better to go with a villain the audience loves to hate, like central banks. Tell the marks that central bankers know the fiat currency system is going to collapse and that they are quietly accumulating gold to reset the system after the crash.

All kinds of compelling evidence can be lined up, like the amount of gold central banks have been buying in recent years. The audience will love it. It fits with their worldview. It explains things like the monetary reserve status of gold in the new Basel 3 rules and why governments seem to ignore market manipulation. It echoes loudly in the chamber.

It is not, however, proven.

All the evidence is circumstantial—and it has other explanations.

But this doesn’t bother the salesmen. It will take years before their big claims can be definitively confirmed or denied. By the time they can be proven wrong—as all the hype leading up to the implementation of Basel 3 has been—they’ve moved on to hawking something else.

Other big theories that have driven exciting copy have proven wrong recently.

Remember being told that the Fed would not raise interest rates to fight inflation because the US government wants to inflate its debt away?

Or that institutional adoption of Bitcoin was taking it to $100,000 (on its way to $1 million) this year?

Or that overpriced palladium was going to send platinum back to its rightful place as the highest-priced “precious” metal?

Or that the silver squeeze was going to bankrupt the COMEX?

Or that the Fed could not let interest rates rise much or it would render the US government illiquid as well as insolvent? (I found this one quite persuasive myself. It may yet prove true—but anyone who bet on the Fed not raising rates much this year lost money.)

Or, a while back, that naked short selling was going to destroy junior mining stocks?

Wash, rinse, repeat.

So how do we defend ourselves?

As an investor, I’m making a case for empiricism over rationalism in securities analysis.

In other words, I’d rather base my decisions on the weight of empirical data than the logical theories of today’s investment Sherlock Holmeses.

I try not to place weight on rational-sounding, but unprovable theories that make the success of my favorite investments inevitable. They may be interesting or entertaining, but they don't constitute knowledge.

I'm especially skeptical if they come with a claim of imminence—that I must act, invest, subscribe, etc., right away to benefit from this supposed knowledge.

As a speculator, I must forecast, of course. But I try to do so based on what I can clearly see is actually happening. I want credible, quantifiable evidence. I want empirical knowledge, not just logical deduction.

Hence my motto: "Forget inevitable or even imminent, I want 'happening now.'"

My other favorite mottos are: "Discipline pays," and "Caveat emptor." Both are relevant.

That's not to say that all big ideas are wrong. It's just that when we find one persuasive, we risk painful mistakes if we fail to seek out all relevant data—especially any that might disprove the theory. The more persuasive the theory, the more vigilant we must be.

And we must be especially wary of macro theories that come with bold investment predictions, the truth of which won’t be known until after the money-back guarantee expires.

That’s my take.



P.S. To be kept abreast of more dangers, opportunities, and issues affecting investors, please sign up for our free, no-hype, no-spam, weekly Speculator’s Digest.



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