Investment : Preparing For Contradictions

One explanation for the appearance of contradictions in investing is that economics and finance are social (or soft) sciences. In a hard science, like physics or chemistry, there are precise measurements and well-defined laws that can be replicated and demonstrated time and time again in experiments. In a social science, it's impossible to "prove" anything. People can develop theories and models of how the economy works, but they can't put an economy into a lab and perform experiments on it. (To learn more, see Is finance an art or a science?) 

In fact, humans, the main subject of the study of the social sciences are unreliable and unpredictable by nature. Just as it is difficult for a psychologist to predict with 100% certainty how a single human mind will react to a particular circumstance, it is difficult for a financial analyst to predict with 100% certainty how the market (a large group of humans) will react to certain news about a company. Humans are emotional, and as much as we'd like to think we are rational, much of the time our actions prove otherwise.

Economists, academics, research analysts, fund managers and individual investors often have different and even conflicting theories about why the market works the way it does. Keep in mind that these theories are really nothing more than opinions. Some opinions might be better thought out than others, but at the end of the day, they are still just opinions.

Take the following example of how contradictions play out in the markets:

Sally believes that the key to investing is to buy small companies that are poised to grow at extremely high rates. Sally is therefore always watching for the newest, most cutting-edge technology, and typically invests in technology and biotech firms, which sometimes aren't even making a profit. Sally doesn't mind because these companies have huge potential.

John isn't ready to go spending his hard-earned dollars on what he sees as an unproven concept. He likes to see firms that have a solid track record and he believes that the key to investing is to buy good companies that are selling at "cheap" prices. The ideal investment for John is a mature company that pays out a large dividend, which he feels has high-quality management that will continue to deliver excellent returns to shareholders year after year.



So, which investor is superior?

The answer is neither. Sally and John have totally different investing strategies, but there is no reason why they can't both be successful. There are plenty of stable companies out there for John, just as there are always entrepreneurs creating new companies that would attract Sally. The approaches we described here are those of the two most common investing strategies. In investing lingo, Sally is a growth investor and John is a value investor.

Although these theories appear to contradict one another, each strategy has its merits and may have aspects that are suitable for certain investors. Your goal is to be informed enough to understand and analyze what you hear. Then you can decide which theories fit with your investing personality.