Proof of Theory

Story Highlights

• Investors often rely on shaky economic theories as truth—a dangerous habit that can ruin portfolio returns
• A better method is debunking unsound theories utilizing the scientific method while implementing well-tested and verified theories with as few assumptions as possible

We're often asked questions like "Do you believe in Modern Portfolio Theory?" or "What is your theory about how stock markets move?"

The answer is: We don't believe in many theories.

Edge, an online community featuring some of the world's elite thinkers, recently published a compendium of new and interesting theories and formulas, ranging from how consciousness works to economic computations for happiness to the number of dimensions in the universe.

What is Your Formula? Formulae for the 21st Century

One theory in particular sparked our interest. Renowned evolutionary scientist Richard Dawkins says the power of a theory can roughly be calculated like this:

Theory Power = Number of Things Explained / Number of Things Assumes

We think that's a great rule of thumb for the validity of investing theories; but we'd take it a few steps further.

If you look at the panoply of economic and financial theory out there, the first thing to note is how much of it conflicts with itself, and just how many assumptions must be baked in to forecasting the real world. Keynesian economics appear true in some cases, but monetarist thinking is clearly better in others. Markets appear perfectly rational often, yet can be demonstrated (often!) to act in ways diametrically opposed to reason.

The need for many assumptions and the appearance contradictory evidence make for shaky theories.

There's a pervasive theory out there that says the higher the valuation of a stock, the riskier it is. A stock with a P/E of 16 is better than a stock with a P/E of 23, for instance. Perfectly logical and makes sense, doesn't it? The lower a stock's valuation is, the "cheaper" it is and therefore a better value.

But it just isn't true! History shows P/Es are not predictive of future stock price returns in a meaningful way. That seems to defy logic—but that's reality.

The same is true for other myths about what affects stock prices: High oil prices, big budget and trade deficits, the falling dollar, and so on. All seemingly logical theories for destroying equity values…yet none are true.

The most recent example is the stock market correction tied to fears over a credit crunch. The theory went that overextended lenders (specifically those in the subprime mortgage category) would spark higher interest rates and a pervasive cash drought that would halt aggregate lending, thusly stinging the economy, sinking stocks and credit markets.

It feels like a perfectly rational premise to believe mortgage trouble, a trillion dollar industry, could significantly negatively impact stocks. But reality showed us just how wrong that logic was. MarketMinder has written much on this subject:

• Ben to the Fake Rescue! (9/19/07)
• Saving the Day (And Not Much Else) (9/18/07)
• Small Cuts Don't Much Matter (9/14/07)
• Are We There Yet? (8/20/07)
• Blood in the Alleys (8/9/07)

What are investors to do with so many bad theories and conflicting results?

MarketMinder thinks successful investors ascribe themselves to concepts that are demonstrably true. Logic is fine and good, but logic can function perfectly well in fantasyland, too.

We wouldn't throw theory out altogether. Many scientific theories hold up rather strongly under the rigors of the scientific method. Further, theory helps us frame the way we think and group like events together to make the world appear more coherent and ordered. But theory can also get investors into a great deal of trouble.

The real problem with theories about stocks and economies, in our view, is it's highly unlikely a theory could be complex enough to take into account all relevant issues in a dynamic economy comprising billions of people and an even greater number of variables.

So instead of adhering to lofty theories all day, MarketMinder thinks it's best to get back into the trenches and employ the scientific method—testing and verifying existing theories about what stocks and the economy really do instead of automatic acceptance. No matter how ironclad the logic, theories are wrong a lot. When theory is mixed with emotion, beliefs are often formed. Beliefs are bad things for investors.

Stick to the verifiable facts and strongest theories when making investment decisions.