As investors, we create theories. We create theories about what will drive future growth. We create theories about the strength of a competitive advantage. We create theories about the people running the companies we invest in.
Creating theories about the future is an important element of investing. So is the destruction of those theories and the creation of new ones. Doing one without the other is the kiss of death in the investment business.
A theory is a set of principles that explain some physical or social phenomenon about the world in which we live in. When we create a theory to explain our observations, we create it based on imperfect information. We try to explain reality, but we can’t observe reality directly. We observe evidence of what is happening behind the curtain, but we can’t peak behind the curtain.
Richard Feynman compared making theories to a chess game where we don’t know the rules. We see snapshots of the board between moves. We make a theory about the rules based on those snapshots. We notice that the black and white pieces move alternately, like taking turns. We quickly learn how pawns move. We see one black bishop stays on the black squares and the other black bishop stays on the white squares. Over time, we get it all figured out, or at least we think we do. We feel good about our understanding of the game.
Then one day we see two black pieces move at the same time. That wasn’t part of our theory. We revise our theory to incorporate the new observation, which was a perfectly legitimate move called a castle. At some point we might see a second black queen emerge. How can one player have more than one queen? We revise our theory.
We can never anticipate every nuance of the game. Even if by some chance we did figure it all out, if we laid out all the rules exactly according to the rulebook, we would never be able to prove that we had done so. We could never definitively say we knew every rule of the game because we can’t observe reality directly. Some detail could emerge that we hadn’t fully considered.
Sometimes we forget that in life and in investing, we can’t see the rulebook directly. We observe and make theories, but we live in a world of uncertainty. Uncertainty for investors is the lack of knowledge about the future. We invest based on our theory of the future, but we never really know what comes next. Even if we embrace uncertainty, it is impossible to lay out all future scenarios. There will always be one that pops up that we hadn’t considered.
Not too long ago, newspapers had a bulletproof competitive advantage, Campbell’s soup had a powerful brand, and shopping malls attracted the highest rents. All that changed and the change came in largely unanticipated ways.
Successful investment operations, ones that delight investors by outperforming the broad market indices, must somehow integrate uncertainty into their mode of operation. How is that done? The way we do it at KP7 is to actively abandon existing theories as new data emerges. Yes, we have theories. We break them. We create new ones. We create knowledge about the game by finding data that disproves our existing theories.
We do not trust investment strategies that claim to reduce uncertainty. They aren’t strategies. They are fantasies. Back testing and controlled experiments don’t work in the investment business. Technology changes. Human behavior changes. The rules of the game change over time. The moment we believe we have the world figured out, our competitor shows up with two queens. How is that possible?
