Friday, February 10, 2023

Kuhnian thinking and investments

Steve Eisman of "Big Short" fame invoked Thomas Kuhn and The Structure of Scientific Revolution to discuss paradigm shifts in the investment world in a recent "odd lots" podcast. Does Kuhn make sense with respect to thinking about investing? Absolutely, but we don't usually think about Kuhn in terms of revolutions of thinking about investments.

With finance research there has been strong shifts in thinking about investing. The switch from efficient markets to a behavioral markets perspective is a simple example. The switch in thinking about factor risk over just market risk is another. The switch to ML over traditional econometrics is a third. These all follow the classic structure of scientific revolutions. The old paradigm does not work and cannot explain the facts, so a new paradigm has to take hold and replace the old.

Investing takes a different approach from the traditional revolution but has some of the same characteristics. There may be a theme or thinking that is used by investors that can no long fit the facts, so a new story has to be developed as a replacement. 

Paradigm shifts are not changes in the business cycle, but something more radical which is a new way of thinking about valuation and pricing. A shift away from cheap money could be considered a paradigm shift. The old ways of thinking about leverage and the cost of capital are changing. A move away from tech-based themes is another shift.

However, this is not a new finance model but a change in emphasis. Is this a paradigm or regime shift? This is a definitional issue, but investors are thinking about how they form a portfolio differently and these new approaches to thinking about themes will impact performance. 

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