Tuesday, December 4, 2007

I don’t trade stocks… I trade theories.

Back when I was in college, one of my economics professors had a saying: “ultimately, the course of history is determined by ideas….”

Positions as Theories

I don’t invest in financial securities, I invest in theories. At any particular present moment, the markets have embraced a certain theory, and my portfolio should be positioned to exploit the effects of that theory. As the collective of market players continually adjust the degree of truth they give to a theory, the value of your portfolio will change. It may not sound significant, but approaching money management with this mental framework is more in tune with the reality of the world. Understanding the flaws in the economic and political institutions that we live in is key to understanding what will happen to a market theory, and as a result, asset prices.

The dominant theory continues to grow stronger...

There is always a theory that is dominant, and at times the markets may change their focus between two theories that are competing for dominance. Other theories wait for their time to come, until their degree of truth (verisimilitude) rises enough for them to have an impact on prices and unseat the dominant theory. The theory that has been dominating the markets most recently continues to grow in strength, or increase its degree of truth…. The name of this theory is “subprime recession.”