Why does philosophy matter?

At the heart of the modern investment industry is a dirty little secret. Wind up sat across from a fund manager, and you’ll hear a lot about ‘investment philosophy’ - but dig deeper, and it usually rests on a few common mantras. ‘Growth at a Reasonable Price’, ‘Long-Term Investors’, or ‘Fundamentals-Focused’. These aren’t unreasonable, but they’re the output of a philosophy, not the inputs. They sell consistency, not results. So what questions should we be asking?

Imagine you’re a value investor considering buying shares in a beaten up company. You do the analysis, work out it’s undervalued, and buy in, sure that you’re right. Six months later, it’s lower than you started, so you check again. You’re still right - your peers are just idiots. But another three months on, you’re even further down. There’s a choice to be made - do you want to be right, consistent, or make money? For most of us, being right tends to come first.

The Western philosophical tradition was built traditionally on a pursuit of these absolute, universal truths, seeking to uncover them through reason, logic, and empirical observations. Plato was writing around 370 BC on the theory of ideal Forms. Abstract truths beyond the physical world. Just as there must be a Form of a chair (the essence of chair-ness), so most investors talk about ‘Quality’ or ‘Value’ businesses with grave certainty. It’s embedded into our view of the world that this reality exists outside ourselves, waiting to be discovered.

Most of us probably fancy ourselves empiricists, in the model of David Hume. He argued that experience and observation were the ultimate sources of knowledge, and warned that our reason is often the ‘slave of the passions’ – we rationalise what our emotions and experiences incline us to believe. But, more challengingly, he would warn us not to extrapolate. Just because something has happened in the past does not mean it will happen again.

If you’ve worked in the industry, you can recite off-by-heart, ‘past performance is no guide to future returns’, but most investment analysis is built on implicit causal claims; rising interests will slow growth, strong management teams allocate capital better, etc. We’re fairly bad empiricists at heart, because it’s a very challenging way to look at the world, filled with uncertainty and doubt.

In 1781 the Prussian philosopher, Immanuel Kant, caused a revolution with his concept of ‘transcendental idealism’, which suggested that we don’t just observe the world and all the things in it, we actually construct reality through mental frameworks. To paraphrase him, we can’t imagine new things without something to base it on; we have a set of ideas about the world, and see everything through them. A value investor and a momentum trader might watch the same stock, but see entirely different things; the former a mispricing to intrinsic worth, the latter a trend to follow. Neither is neutral, but seeing things in their own way.

Trial and Error

Where Hume warned us not to trust intuition, and Kant suggested we box and interpret reality in our own ways, Karl Popper emphasised falsifiability, broadly scientific method where we learn by eliminating falsehoods. He held that we can never know anything with certainty, only hold tentative hypotheses which survive, for a while, our tests of falsification. Investors are rarely keen to be falsified, however; the average research note contains enough insight to be original, and enough consensus to avoid blame. Forecasts are kept broad, making it harder to be embarrassed by errors, a topic I’ll address in greater detail in a future article.

It shouldn’t come as a surprise to us that George Soros, perhaps the most philosophically self-aware investor of recent times, explicitly credited Popper for shaping his world view best summarised in his theory of Reflexivity. This theory suggested that markets are not stable systems moving toward equilibrium, but dynamic systems in which participants’ beliefs shape outcomes, which in turn reshape beliefs.

Not only are our beliefs fallible, but those beliefs feed back into the system itself in a Kantian framing, creating a moving target. There is no fixed reality behind the market for us to uncover. The market is a reality created by the interactions of fallible beliefs; the epistemological instability of markets (the uncertainty of knowledge) is structural, not incidental. His theory offers a more dynamic, probabilistic, and falsifiable but shifting conception of reality.

Although Soros credits Popper, he arguably more closely resembles Thomas Kuhn, who offered a more disruptive vision in his 1961 book, Structure of Scientific Revolutions. Kuhn, a scientist by background, argued that knowledge advanced not gradually but through periodic revolutions called paradigm shifts, in which an entire worldview collapsed to be replaced by another.

For him scientists, and for us investors, engaged in solving puzzles within the dominant paradigm until, eventually, too many anomalies accumulate which the model couldn’t explain. Confidence would erode, and eventually a disruptive young scientist would kick the table over and upset everyone with a new paradigm - think Newton, or Einstein. In the 20^th Century there’s a clear example in the abandonment of the Gold Standard in 1971 – after decades of global currencies being pegged to the precious metal, economic pressures and imbalances led to a collapse of the system and the paradigmatic shift to fiat currencies with the emergence of monetarism.

This echoes Soros’s warning that market trends were often self-reinforcing rather than naturally correcting and could continue for far longer than a neutral, logical actor might expect until at last something shifted to break the spell, perhaps more so than Popper’s gentle advancement of knowledge through scientific process. His example in The Alchemy of Finance of Reagan’s Imperial Circle, in which a strong dollar created a virtuous cycle over many years, reflects Kuhn’s more paradigmatic view – the complexity of investment analysis and thinking has tended to advance, but has shown limited capacity to challenge paradigms. If anything, Cliff Asness of AQR has warned that markets have become less efficient over time at challenging these sorts of cycles.

Our troubles in understanding this shifting world even extend to the language we use to describe it. Consider how something like Value investing has changed; its core thesis of price relative to intrinsic value predicting returns, has remained intact but the auxiliary hypotheses have changed – our view of quality, balance sheet strength, ESG, or capital cycles have evolved, and we have sought justifications in interest rates, style rotations, and intangibles. Faith clings to the model even as its predictive power declines.

Going with the flow

So what happens if we simply abandon models, logic, and rationality behind markets. If, instead, we just go with ‘what works’ for now and avoid overthinking it?

This attitude arguably underlined one of the 20^th century’s most successful hedge funds, Renaissance Technologies. Rather than learn or integrate economic theory and market analysis, the Jim Simons’ firm simply sought to find statistical patterns that work, evaluate when their utility declines, and move on. Rather than starting with theory or purity, Simons picked up the torch of the pragmatists and moved straight to the findings.

Simons’ concept is a deeply troubling idea for most investors – doing something because it simply works right now, rather than driven by a fundamental theoretical view on truth – because it undermines our intellectual confidence in what we do and, we fear, exposes us to being caught out if the signal stops working.

But this pragmatic, dynamic world view - taking things as you find them, shrugging, and working with it - while alien to most western thinkers, isn’t entirely without precedent. Where the West has grappled with its search for Truth and objective reality, grappling with the world to put it in a box and analyse it, Eastern philosophies have often shown an admirable relaxation to it all. Take Laozi’s Dao De Jing, a collection of Chinese wisdom dating to around the 6th to 4th century BC, interestingly still sometimes taught in Chinese business schools. Where we seek frameworks to understand reality, Daoism seeks attunement instead to its fluidity; “The way that can be spoken is not the eternal way.”

In this system, the world is not a system to be decoded, but a flow to be sensed. The central concept of Wu Wei (无为), is commonly translated as ‘non-doing’ or ‘inaction, and even used as an appeal to the wisdom of passive index-tracking funds. It’s also wrong - it’s not ‘inaction’ but ‘effortless action’, the idea of acting in harmony with the natural order. Like water, it suggests we should follow the natural path. The virtue is not passivity, but spontaneity and adaptation to change. We should allow our view of reality to change with it, rather than seek to bind it, and swimming with rather than against the current of ideas - unless, of course, you have the assets of Soros to hand and can move the markets yourself, which Laozi failed to consider.

Putting it together

We tend to convince ourselves that we are in a quest for 'truth', uncovering the real nature of things beyond us through research and the synthesis of signals. We may even feel ourselves successful in doing so. It's a tragedy that, all too often, the discovery of truth doesn't yield us the benefits it ought to because we are, as Keynes put it, not judging the beauty of the contests in the pageant but merely anticipating the judgements of others.

Markets can continue in delusion for a very long time, perhaps not beyond our point of solvency, but certainly beyond the patience of our clients or our own mental tolerance. Stan Druckenmiller, the legendary hedge fund investor who ran George Soros's Quantum fund for many years, bitterly recounts his lasting scepticism of the Dot-Com bubble, remaining out and watching stocks race upward. Eventually his emotional resilience cracked and he entered just in time to catch the collapse of the bubble. Sometimes, other pressures intervene - social, or biological - and force our hands, so we might as well go in with eyes open to the possibility, and perhaps even pre-empt it.

So how should we build our philosophy?

Fundamentally, we need to orient ourselves around our goal - making money. It’s not quite the same as ‘being right’, but rather an embrace of pragmatism to do what makes sense at our present point in time. We can’t allow ourselves to lean on notions of objective, unchanging reality or eternal truths. The very paradigms of markets can shift, sometimes with alarming speed. Instead, we need to be nimble, not placing too much weight on any belief and having the spontaneity and flexibility to adapt to change.

At times that might mean buying value stocks as we perceive a shift in market preferences, at other times it might mean jumping on a momentum wave we know probably can’t last. Better to be in early with a finger on the ejector button than forced in by FOMO and client pressure when the bubble is ready to burst. And when markets seem to be breaking down and logic collapsing, we need to be ready to stand back and wait for a signal to move and participate.

Not unlike sailing, a favourite hobby of mine, there are two elements to the journey. We can get a sense for tides and currents at sea and in markets, plan a course, and have a strategy. But wind and waves can be unpredictable and change rapidly - we need a fusion of intellectual awareness and instinctual reactiveness.

By being aware of the limitations of our thought, the dangers of paradigm shift, and being open to flexible pragmatism - moving with, not against, the flow of markets - we have a chance of surviving, and perhaps even thriving.

Over the next few essays I’ll be diving into Risk (what it is, and how I navigate it), People (how we think and feel), and Structures (the roles of incentives, institutional binds, and more).