Empiricism, Instrumentalism, Critical Rationalism and Value Investing – Part II – Yahoo Finance

- By Grahamites

In a previous article, I briefly introduced empiricism, instrumentalism and critical rationalism. They are three different attitudes towards knowledge acquisition as well as three different theories about how to acquire knowledge. Each also has a different definition of rationality.

I won't go into the details of each school of thoughts. What resonates with me the most is critical rationalism, an idea brought about by Karl Popper in the middle of the twentieth century.

Some readers might not be familiar with Karl Popper. In my view, Popper is one of the most underappreciated thinkers who has had great impact on some of the most prominent financial figures in our time. His most famous student is George Soros (Trades, Portfolio). Nassim Taleb's thinking is also heavily influenced by Popper. Therefore, when I saw Popper's name on Li Lu's recommended list, I knew I had to read his books.

Popper's most important work, in my opinion, is his theory on scientific knowledge. He started to grapple with the problem "When should a theory be ranked as scientific?" or "Is there a criterion for the scientific character or status of a theory?" at age seventeen. He was interested in four theories then - Marx's theory of history, Freud's psycho-analysis, Alfred Adler's individual psychology and Einstein's theory of relativity.

Of them, he found Einstein's theory strikingly different because the risk involved in Einstein's prediction was very high. If observation shows that the predicted effect is absent, then his theory is simply refuted. In other words, the theory is incompatible with certain possible results of the observation. Later, Popper summed it all up by saying that the criterion of the scientific status of a theory is its falsifiability, or refutability, or testability.

Popper suggested that both science and philosophy should use the method of rational or critical analysis "of stating one's problem clearly and of examining its various proposed solutions critically." When I read Li Lu's book, I particularly noticed the frequent mentioning of scientific method and rationality. It appears to me that Li borrowed the idea from Popper. Not surprisingly, this is also what Charlie Munger (Trades, Portfolio) believes.

We often hear that value investing is partly artistic and partly scientific. If so, shouldn't we use the scientific method for the science part? Shouldn't we first clearly define what truth and rationality are?

I view this as a critical issue in value investing because value investors define rationality and truth differently. For instance, some believe in "rule of thumb" and historical valuation analysis. One issue with this approach is that you can't falsify valuation analysis. For instance, an investment thesis might be stated as Wells Fargo (NYSE:WFC) should trade at 14 times earnings. It's impossible to refute them because you can always argue that first of all, Wells Fargo (NYSE:WFC) has traded at 14 times earnings in the past multiple times. And secondly, it could trade at similar multiples in the future because it's the fair value. This is the empiricistic way of investing, which some value investors use.

On the other hand, the rationally critical value investors would propose falsifiable theories and actively seek contradictions. For instance, a falsifiable hypothesis regarding Wells Fargo (NYSE:WFC) would be that its cost of fund is the bank's sustainable competitive advantage. This is falsifiable because if in the future, Wells Fargo's cost of fund rises above its peers, then the hypothesis is invalid.

Above is just one example of how different ways of viewing rationality may lead to different ways of behavior. In practice, different views will inevitably lead to different approaches to research and actual investment decisions.

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Empiricism, Instrumentalism, Critical Rationalism and Value Investing - Part II - Yahoo Finance