Unprovable contentions

15Aug06

Part of what we do here at Abnormal Returns is to look for items outside the realm of finance and investing to help illustrate important concepts. For instance, we discussed how recent research into “rogue waves” can help us to understand the idea of stock market crashes.

That is not to say that there is not much to learn from the world of academic finance. While much of academic finance has little to say to the individual investor, the theoretical and empirical work from this realm has much to say to how we as investors go about building portfolios.

We were reminded about the importance of empirical testing in reading an article by Michael D. Lemonick at Time.com on the “unraveling of string theory.” Lemonick does a nice job of both describing string theory and why opinion is turning against the theory.

String theory is an extraordinary complex topic in theoretical physics that is seeks to (in short) be “the theory of everything.” The problem is that the theory is largely untestable. The basis of science is hypothesis testing. Without a way to test string theory it is impossible to say it is true or false.

It was bad enough, they say, when string theorists treated nonbelievers as though they were a little slow-witted. Now, it seems, at least some superstring advocates are ready to abandon the essential definition of science itself on the basis that string theory is too important to be hampered by old-fashioned notions of experimental proof.

We recommend the piece as a whole. As Lemonick notes it could very well be the case that string theory eventually proves itself to be the answer to the most important questions in theoretical physics. That however will not occur until some physicist can come up with a way to test it.

Every one involved in the markets can remember being presented with some “grand theory of the markets” that on the face of it seemed to make sense. However after a modicum of probing it was clear that this so-called theory was little more than the figment of an overactive imagination. Finance, while not a science, does have the benefit of empirical testing.

So the next time you hear about some really novel investing concept, step back and ask yourself a couple of questions. 1. Is this concept supported in whole (or in part) by established financial theory? 2. Is there any empiricial evidence to support said theory? If not, run, don’t walk away.



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