Blinded by Theory?

Abstract

Theories are but theories; they help us understand how the world should work. There's no harm in raising arguments that suggest the world works somewhat differently from the theory, but often the investment community accepts theories and their underlying assumptions as fact. All too often, we prefer to operate on the basis of heuristics or shortcuts, some shaped by theory and others by convention, rather than examine our core assumptions; these heuristics can set the stage for error on a massive scale. We forecast the future by extrapolating the past, and assume that retained earnings will be reinvested more wisely than if shareholders received this cash in dividends to fuel future growth. Investors and academicians too rarely test their hypotheses, or they accept the data if they contradict the theories.