The Scientific Method and Value Investing

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.