Mistaking Theory for Law

by | Jun 7, 2017 | Asset Management

Recently, I’ve been doing some studying for the CFP exam. I keep coming across a certain phrase, “all else being equal”, which comes from the Latin ceteris paribus. Whether you’re studying finance, economics, psychology, or biology you’re bound to come across it eventually.

What ceteris paribus does is exactly what the translation says. It holds all other variables constant to examine an isolated cause/effect relationship. For example, all else being equal, if people like to eat chicken and the supply of chicken dwindles, the price of chicken will go up. In reality, all things are rarely held equal. Consider this: what if the supply of chicken is dwindling because of bird flu and people are afraid to eat chicken even though they like it? Will the price still rise?

“All else being equal” is a tip-off that you’re dealing in theory. In science, theories begin as a hypothesis and attempt to explain why and how something happens. This contrasts a scientific law which explains what happens.

Finance, in comparison to something like physics, is a lot less clear. The line between theory and law is blurry. We have many useful theories that, with current data, are the closest things we have to laws. However, they aren’t irrefutable. They’re more like strong theories that contain minor exceptions.

For example, the equity risk premium tells us we will earn more money investing in the stock market than in Treasury bills or cash. As shown below, this has proven to be true, especially over longer time periods.

However, there have been stretches along the way when investors probably wondered if the equity risk premium really existed.

That’s because the equity risk premium is a theory and not a law. All else being equal, the stock market should offer higher returns than treasury bills. However, if people are spooked out of the market or the economy enters a bad recession, it may not for a period of time. The market doesn’t have to give us returns greater than treasury bills or cash. It probably will, but we cannot know for sure, especially over short time periods. This is the difference between theory and law.

Unfortunately for investors who crave absolute certainty, we have plenty of solid theories, but lack laws. In turn, people often rely on theories to guide their decisions. If you rely on strong theories (like the equity risk premium), you’ll be right more often than not. However, reliance on even the strongest theories can also make very smart, reasonable people look incredibly stupid from time to time. This is a feature, not a bug. Investment returns get destroyed when people doubt their very good theories that just happen to be experiencing an intermittent exception to their otherwise strong thesis. In the absence of true laws, we’ve elevated strong theories to their place and forgotten that there will be exceptions. Then, when the exceptions occur, we remember that they’re only theories and worry they’re not as strong as we thought.

It’s important to understand theoretical concepts because they build a basis for us to make sense of complex situations. However, we also need to acknowledge their limitations. Things tend to get particularly messy when several “all else being equal”‘s get layered on top of one another. When you think about it, that’s pretty much what investing is, which is what makes it so difficult. There’s no way around making theoretical assumptions, we just need to be comfortable with the ones we choose to accept.

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