As investors, we create theories. We create theories on the quality of a management team, the durability of a company’s competitive advantage, and the predictability of a company’s underlying earnings stream. We combine those theories in an assessment of which stocks will go up.
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 actually peak behind the curtain.
There is reality on one hand and our interpretation of reality on the other. The two are different.
Richard Feynman compares making theories to a chess game where we don’t know the rules of the game. We see snapshots of the board between moves and we theorize about the rules from those snapshots. We notice that the black and white pieces move alternately, like taking turns. We quickly learn how pawns move. We see that 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 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 on the board. How can one player have two queens? After years of watching the snapshots between moves, we notice two black bishops suddenly both occupying black squares. We revise our theory.
That’s odd. We actually learn more about the actual rules of the game through the observations we make that don’t fit our theory. We can make thousands of observations that do fit our theory and not learn a thing. One inconsistent observation has the potential to take us to a different level of understanding. All we have to do is see it, abandon our old theory, and create a new one.
For any of you that have read Karl Popper, you know we owe one massive shout-out to him for that observation. Popper tells us that we learn about the world around us not through proving our theories right, but by proving them wrong. It’s true.
Popper also warns us about the dangers of being overconfident about the accuracy of our theories.
After seeing two black bishops occupy black squares at the same time, we start to see his point. We start to wonder if perhaps there is always some nuance to the game that we haven’t quite figured out. “No theory should ever be relied upon as the final truth” Karl Popper tells us. Even the best theories are approximations of the final truth, not the final truth itself.
If by some chance we do have the game all figured out – we lay out all the rules exactly according to the rulebook - we could never prove that we had done so. We would never be able to say definitively that we knew every rule of the game. We simply don’t have access to the rulebook. Theories, in that sense, can never be fully verified. Another shout-out to Mr. Popper.
As investors, the closer our theories align with underlying reality, the better our investment track record. We get closer to reality by observing the data point that doesn’t fit our theory.
The biggest mistakes we make as investors is failing to see the inconsistent data point. Inconsistencies can have very subtle expressions. They are easily missed. Oddly enough, as humans our minds are wired to pick up data that confirms our theories and discount or ignore the data that doesn’t. Successful investors fight against that tendency. They fight against the tendency to ignore or discount data that, if properly analyzed, will get them closer to reality.
