I’ve talked a bit about how to arrive at ideas. We have come across two techniques: induction, in which one obtains knowledge by analysing events, and deduction, in which one builds an understanding via axioms/principles and uses these to arrive at conclusions using logic/rules.
But how do we know when the ideas are obtained using these techniques are correct? Or, generalising, how do we know when any idea is correct? How do we know when we actually know something?
This subject, more properly called Epistemology, has been studied by philosophers (and mathematicians) for thousands of years. Aristotle, Locke, Kant (and others) all attacked the question which should be, in my view, their top priority. If we can’t know how to know something then we can’t know, well, anything.
There may also be answers from mathematics. Gödel proposed his famous incompleteness theorems in the 20th century. His idea was that there can be no mathematical system constructed from axioms that is both consistent and complete. You can’t think up axioms that both prove the existence of themselves. You always need some principles to start from that cannot be deduced from those principles.
This seems to be the contemporary approach to knowledge. One must start from a set of principles or ideas and build from this set. The set itself, however, may be constructed unscientifically. We see this approach from Ray Dalio with his “Principles”, or from companies with their “values”. You see it too in Silicon Valley with the recent fetishisation of “first principles thinking”. These principles inform action – not the other way around.
How are these principles obtained? They apparently magically materialise out of thin air. What’s more, most people seem to have the attitude that once these building blocks are in place they are set in stone. It certainly feels strange when principles are changed – imagine mathematicians suddenly propose that 1 + 1 = 3. This doesn’t feel right. However, there needs to be some kind of mechanism that allows principles to mutate (or at least come under some type of critical evaluation). What cannot change is unable to adapt. What is unable to adapt, eventually dies or is replaced. I see the process as less of an arrow (as above) and more of an interconnected system, with each stage informing the others. Principles are formed vaguely via induction, affecting action via deduction and the consequences of these actions feed back into principles via induction again. It’s a system, not an arrow.
This system tells us how to use what you know to inform how you act.
- Principles: These are your main ideas. They aren’t necessarily practical or logical or statistical.
- Strategy: How do these principles affect how you act, in a broad sense? How do you operate? What’s your over-arching strategy?
- Tactics: The actual, nitty-gritty, implementation of this strategy. What actions does this strategy lead to?
As you can see, each layer comes from the previous one. There can be no strategy without principles and no tactics without strategy. I must also mention the fact that the layers are increasingly unimportant. With the wrong principles, you aren’t going to succeed regardless of how flawless your execution (using tactics) is.
I personally find myself learning most effectively via example, maybe some of you will be the same. Let’s take one of my principles and think about what this system might look like for one particular path down the tree.
- Principle: Focus on the bigger picture.
- Strategy: Don’t worry/think about low-cost expenses.
- Tactic: Don’t put a lot of time into anything that will save you less than £100.
Or, in a completely different context:
- Principle: Play attractive football.
- Strategy: Everyone must be comfortable on the ball.
- Tactic: Purchase ball-playing centre backs.
See how things become less abstract as we move down layers but, ultimately, everything is built on the principles.
Regular readers (all 3 of you) will have noticed by now that things are never as simple as I first mislead you into thinking they are. You see, this picture that I beautifully painted above neglects the fact that each layer and each path have different levels of certainty in the mind of both society and the operator.
Let me explain. We don’t know anything, really. Nothing is a true certainty. There are some things that are practically certain, things that have probability > 0.99999999… of being true. But the fact remains that nothing actually has probability 1. Everything exists on a spectrum between 0.99999…..999 and 0.00000…..00001. Everything has a degree of uncertainty attached to it. A width of uncertainty, as I call it. What’s more, similar to the system above, we tend to stack less-certain beliefs on top of more certain ones. Mathematics is generally regarded as being more certain than physics, so physics is built on top of mathematics. The fact that you have to lift weights to grow your muscles is more certain than which exact technique is best to do this, so all of these techniques are stacked on the idea that one must lift weights. As you move up the pyramid, thinking diverges as certainty decreases.
How does this relate to our principles-based system of thinking and acting from above? To be honest, there is no neat-and-tidy way that it does. What is clear is that principles are not ever-lasting. Some new discovery or understanding can wipe out even a very certain piece of knowledge (or a principle). The main point, I think, is that one should always be open to the possibility that principles can change…and the degree of belief surrounding those principles can change, too.
Investing is hard
This field, like most, is largely composed of opinions. Probabilities are unknown. General advice is pretty useless. No one knows the answers.
The complexity of financial markets, and the economic system as a whole, ensures this. This may be at first glance horrifying but it has its benefits. You see, we know that there is generally more uncertainty than most people perceive. This somewhat simplifies the decision-making process. If you don’t know which asset is going to give you the highest return, how would you invest? You’d split your investments evenly. A very simple decision. If you know that an asset’s price could fluctuate wildly and even go to 0 with some non-trivial probability, you wouldn’t invest all your money into that asset.
This is what Perpetual Prudence is all about. We’re trying to solve Lifetime Investing: how to invest when there is a lot of uncertainty about a lot of things. Acknowledging the uncertainty is the first step of this process.