Wednesday, November 14, 2007

The Logician

Plato, through the character of Socrates, has a specific method of presenting his position on a given topic. His method of argument being comprised of three steps:

1. Starting with certain premises
2. Through a process of reasoning, leading his opponent to
3. His conclusion

The only way to dismantle the so-called “Socratic method” of argument is also a three-step process:

1. If the truth of the first is challenged successfully
2. And if the remaining premises that are based on original premise follow logically
3. The conclusion is false

Now the first time I read this, I didn't really understand its significance. It seemed to me a pretty obvious statement. But while sitting in class a few days back I had a striking thought about this quote and about technical analysis. What are the initial premises which form the basis for technical analysis? It appears to be the idea that a stock's future price can be dictated by its past price action. But that premise can be so easily challenged, and there seems to be no way to show how or why past price action has any effect on future stock price. The only thing I was able to think of is that if you see large volume of buying, that perhaps this signifies a big buyer is trying to accumulate stock and so this should push the price upwards in the near term. But this is easily challenged, too. 1) You have no idea whether this buyer is done buying or not. 2) If you are basing your logic on the fact that you are following buyers who have come up with their own sound reasoning, then that is flawed too- everyone has opinions, most will likely be wrong. And for every buyer there is a seller, so someone else is obviously disagreeing.

Now compare that to the idea of value investing. By value investing I don't mean buying beat-up companies or companies that appear cheap. I mean buying companies for less than their expected discounted cash flow. You can challenge this by asking, "what's to say a company will eventually trade at its DCF?" There is a solid response to this though: the company can use this cash flow to pay out dividends, ensuring that an investor will recognize the value of his investment. "What if they don't pay out their cash in the form of dividends?" Then investors can get on the board and force this to happen. "What if the board and founders own a majority stake and refuse to treat shareholders properly?" Well, in that situation, you might be out of luck. Still, we see that the foundation for value investing is based on a much more solid framework.

Now despite this shakiness to the ideals of technical analysis, there is no shortage of people who have faith in this system. Just turn on CNBC one morning and you will see for yourself. And they have come up with elaborate techniques and fundamental rules, yet they don't realize that the foundation of their entire belief structure is suspect.

And unfortunately, I think this is prevalent in society. And a lot of bad habits are taken up because people will just accept a certain premise and never challenge it, and then go all their life never looking back on it. Warren Buffett has said every year you should throw away at least one of your most cherished beliefs. So, the past few days I have stopped every now and then and asked myself, "hey, why am I doing this or why do I believe that?", and it has been a very enriching exercise that I recommend to others. If you are honest, it will help you to better understand yourself and the world around you.

1 comment:

Captain Reality said...

"Warren Buffett has said every year you should throw away at least one of your most cherished beliefs."

Actually, I believe it is Charlie Munger who advocates continually challenging your "best-loved ideas".

At the 2004 Wesco meeting, he said (per Tilson's notes): "Any year that passes in which you don’t destroy one of your best loved ideas is a wasted year."

P.S. I love your blog - especially the company-specific discussions. Keep up the good work!