The Scientific Approach to Investing

If you’re one of the lucky ones, you’ve made it past 6th grade, where you probably learned about the scientific method for the first time.  You probably had to apply the scientific method while dissecting some little animal (who, by the way, had it coming) and you would make sure you went through all the steps in order to get the full grade for the experiment.  In case you haven’t refreshed on the method in the past decade, let me give you a little reminder.

The steps are, in this order:

1.) Make an Observation

2.) Form a Question

3.) Form a Hypothesis

4.) Conduct an Experiment

5.) Analyze the Data and Draw a Conclusion.

Ringing a bell now?  Good!  Well, as you may know, people are extremely tied to their beliefs about the world around them.  They tend to identify those beliefs as being core to who they are as a person.  This is why when you challenge somebodies political beliefs there’s a high probability they will become angry and defensive.  They feel that it’s an attack on who they are, rather than the belief they are holding.  Presumably, this has only become worse with time since everyone can go to “iamright.com” and support these beliefs that they hold onto.  Believe the world is flat?  There’s a website for that.  You believe that Hillary Clinton is a reptile?  There’s a website for that.  Or, my personal favorite, that Nicholas Cage is our Lord and Savior.  If you believe that, there’s a community of people who can support your beliefs!

You may be saying, “Although Nicholas Cage is my savior, I don’t see how this applies to Investing.”  Fair point.  However, it applies directly to investing because searching websites that confirm your beliefs are related to a phenomenon called confirmation bias.  Confirmation bias is when somebody filters out information that doesn’t fit with their narrative and actively searches for information that confirms their beliefs.  For example, let’s say you spent 20 hours researching company XY and you decide that it’s a great investment because their financial statements look strong and they are trading a good valuation.  You decide to invest 5% of your portfolio into company XY and are expecting a 15% return over the next year.

Can you spot where the beliefs are?  First, you have a belief that it’s a great investment because of two subjective beliefs about the financial statements and the valuation.  Second, you have a belief that you will return 15% in the next year based off of your first belief.  Now, having beliefs are not a problem.  Believing in things are part of investing and part of being a human being.  However, the problem arises after the initial beliefs because the average person will identify with those beliefs and hold them as if they are a piece of them.  Having beliefs be right confirms that they know what they are doing and that they are smart.  It protects them from the pain of being wrong and the embarrassment that can follow being wrong, especially when it’s your own money.

 Since your purchased XY stock it has gone down 4% and you begin to look up every news article on why the stock should go up and why it should be a great investment.  You look for any piece of information that can confirm that you are right because being wrong would mean that, well, you were wrong!  Who wants to face the fact that they made the wrong decision when they can simply look up all the reasons why they should be right?  Not many people.  We are programmed to seek short-term good feelings.  We are addicted to that rush of dopamine that confirms our beliefs.

You may be saying, “Well this is just how we’re all wired, what the hell am I supposed to do about it?”  Good question, but calm down and don’t kill the messenger!  What am I purposing is applying the scientific method to investing, where you observe, hypothesize, and test to disprove your hypothesis.  Look for any holes in your logic rather than look for more ways you can be right.  Read all of the dissenting news articles you can get your hands on and analyze them.  Look through financial statements, economic indicators, and technical indicators with the mindset that you’re going to disprove your original ideas.  You should do this even though it will hurt to constantly read things that are disagreeing with you and your logic because if you can’t find anything wrong with your logic it probably means it’s adequate until it isn’t anymore.  If you’re constantly trying to prove yourself right, then you will never see the day when the original logic you had with an investment turns itself on its head.  Whereas, if you’re actively searching to disprove yourself, the day your original argument for why something was a good investment change because of conditions changing, you will spot it and be able to adjust.

The key is to remember that dissenting views and facts are disagreeing with ideas and they are not disagreeing with you as a person.  By remembering that, you will be able to separate yourself from the usual pain and embarrassment of forcing yourself to read and search for dissenting facts and opinions.

Since that investment in XY is down 4% you should look for all the fundamental reasons that it might have gone down 4%.  Was it the general market?  Some fundamental factor?  Or, was it just noise?  It is important to figure these things out, because if it went down 4% for a reason that wasn’t a big deal then there’s no reason to change your original hypothesis about XY being a good investment.  If you find something to disprove your original hypothesis, then it would be important to reevaluate your investment.  Do you see the difference in the two approaches?  Originally, you were searching for the reasons why it shouldn’t go down 4%, opinions that confirm your original hypothesis.  This way of investing would blind you from any changes or holes in your original hypothesis.  Whereas, actively trying to falsify your original hypothesis will give you more confidence if you can’t do so and save you from costly mistakes if you are able to falsify it.

This message is brought to you by science and 9/10 dentists recommend it.