10-year

10-Year Anniversary Promotion (20% off)

Join GuruFocus Premium Membership Now for Only $279/Year

Once a decade discount

Save up to $500 on Global Membership.

Don't Miss It !

Free 7-day Trial
All Articles and Columns »

The Scientific Method and Value Investing

July 05, 2014 | About:
Grahamites

Grahamites

152 followers

It is often said that value investing is both art and science. Every value investor may put a different weight on the science part versus the art part. Jack Bogle thinks investing is more science than art while Seth Klarman (Trades, Portfolio) thinks investing is more art than science. Regardless of different perceived importance of the artistic and scientific element, it is undeniable that investing does require a rigorous, evidence-based approach which involves collecting, analyzing and interpreting data to test a hypothesis. Hence, as value investors, shouldn't we apply the scientific method when doing the analytical work.

You may ask, what in the world is the scientific method then? You may find it extremely amusing if a business major who has no science background whatsoever to explain what scientific method is. Therefore, I will not embarrass myself. Instead, I’ll quote Richard Feynman -

“Scientific method is based on the principle that observation is the judge of whether something is so or not. All other aspects and characteristics of science can be understood directly when we understand that observation is the ultimate and final judge of the truth of an idea. Or, put another way, ‘ the exception proves that the rule is wrong.’ That is the principle of science. If there is an exception to any rule, and if it can be proved by observation, that rule is wrong. So the more specific the rule, the more powerful it is, the more liable it is to exceptions, and the more interesting and valuable it is to check. The method is “try it and see’ and accumulate the information and so on. And so the question ‘if I do it what will happen?’ is typically scientific question.”

"In general, we look for a new law by the following process. First, we guess it.Then we compute the consequences of the guess, to see what, if this is right, if this law we guess is right, to see what it would imply and then we compare the computation results to nature, or we say compare to experiment or experience, compare it directly with observations to see if it works.

If it disagrees with experiment, it’s wrong. In that simple statement is the key to science. It doesn’t make any difference how beautiful your guess is, it doesn’t matter how smart you are who made the guess, or what his name is… If it disagrees with experiment, it’s wrong. That’s all there is to it.”

I encourage the readers to watch the following video clips:

http://www.presentationzen.com/presentationzen/2014/04/richard-feynman-on-the-scientific-method-in-1-minute.html

So the process really goes like this.

1. We guess, or develop a hypothesis.

2. We predict what would happen if our hypothesis is right.

3. We observe and impartially consider data and look for disconfirming evidence.

4. We review the hypothesis.

In investing, we also form hypothesis all the time. In fact, most of the time, our investment thesis is really just a hypothesis. For example, if the thesis is that we should buy Coca Cola because it is undervalued. The hypothesis is Coca Cola’s intrinsic value is more that its market price.

In my opinion, investing differs from science in that very often the hypothesis can not be definitively proven right or wrong at the time of thesis origination because the correctness of the hypothesis depends on what will happen in the future. But this doesn’t mean we should abandon the scientific method. We should break the main hypothesis into subhypotheses and predict what would happen if each of our subhypothesis is right. We should gather, analyze and interpret the data and pay special attention to exceptions or disconfirming evidence. Then instead of establishing a theory or a rule, we review our main hypothesis, based on what we think what would happen in the future. Finally, as future events start to unfold, we should update our evidence database and evaluate whether our hypothesis is holding up or not. We then make decisions thereof.

I know this article may sound a little abstract and unorthodox. To tell the truth, the scientific method didn’t occur to me until recently while reading books on Richard Feynman. I didn’t major in science in college and graduate school so this is all relatively new. However, I am extremely intrigued by the scientific method. This article is just a starting point. In the future, I will try to write some articles on the application part.


Rating: 4.3/5 (12 votes)

Voters:

Comments

vgm
Vgm - 5 months ago

A fascinating topic, Grahamites! As a scientist, I've long wondered why more investors have not adopted this approach. It brings discipline and rigor to our methodology.

Ken Shubin Stein of Spencer Capital is an investor (and scientist) who overtly and systematically applies scientific method to investing - a couple of articles can be found here:

http://www.beyondproxy.com/tag/spencer-capital/

http://ify.valuewalk.com/wp-content/uploads/2014/02/Graham-Doddsville-Issue-20-Winter-2014.pdf

Of course, much of investing is qualitative, so we need to be less quantitative than a scientist would be, but nevertheless practising scientific method leads to a useful and practical mindset.

I'm sure Charlie Munger would applaud your topic!

Thanks!

Grahamites
Grahamites premium member - 5 months ago
Vgm - First of all, thanks for you very nice words and thanks for sharing those fabulous articles. I admire your background as a scientist. Sometimes I wish I had a science background:)

Charlie Munger (Trades, Portfolio) would be a great scientists just as Richard Feynman would be a great investor in my opinion. I think the reason why so few investors adopt this approach is that it is too damn hard. Think about it, you have to make so many hypotheses when analyzing a company. All the future projections are basically hypothesis. It's easy to make an uneducated hypothesis but it's very hard to make an educated hypothesis. It's even harder to test your hypothesis because 1) you may not realize you have to test your hypothesis, 2) you may not know how to test it and 3) it takes additional time and effort to test it if you decided to do so.

So I'm not surprised by the scarcity in adoption of the scientific method. And you are absolutely right in saying that it brings discipline and rigor to our methodology. I'm still in the infant phase in terms of applying it to my investment process but thoroughly enjoying it so far:)

Thanks again for your comments.

Ian New
Ian New premium member - 3 weeks ago

Very insightful indeed. Modern finance has envolved and it is more science than arts now.

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK