Friday, May 27, 2016

The language of finance: From hypotheses to models and story-telling

The language of science is actively used in finance to describe the activities of academic researchers, but there also is a language of investment management that describes what managers do. This language is often different and at times, at odds with the language of science.

While investment managers engage in financial research, they often do not use words like hypothesizing.  Yet, often what they are actually doing is proposing and testing hypotheses. The investment manager will often use the language of cases and story-telling as opposed to hypotheses and testing. This distinction is important when conducting due diligence. Similarly, investment managers will talk about quantitative models but will often revert to the language of story-telling and descriptions of specific situations as opposed to discussion of levels of significance and probability.

Although it can be viewed as simplistic and stylized, academic financial researchers observe phenomena from data, form models, and test their hypotheses. They often engage in the classic scientific method. Researchers learn from their failure, bring forth new explanation for data, and attempt to advance the science of finance through their ongoing research. Albeit stylized, finance researchers engage in forming conjectures, testing, and learning from failure. There is a focus on inductive logic.

Investment researchers may do the same but may not want to admit it as a process of testing the markets with ideas. Hypothesizing is not usually a word used to describe the research or commentary from investment professionals.They do not like to say that they hypothesize an investment idea and then have it "tested". There is less generalization and a greater focus on specific events and special situations. Nevertheless, there is also a focus on deductive logic whereby there is a theory or story to explain market behavior and then a search for confirmation of the story.

There is switching between inductive and deductive logic by investment managers as well as academic research. It is important for an investor to understand when and how managers move between forms of logic and how they form their theories and test their ideas. 

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