One important element of the scientific method is having a properly constructed hypothesis. One of the essential characteristics of a good hypothesis is that it can be refuted or contradicted by an observation or physical experiment. Scientists call this characteristic falsifiability.
Likewise, one indispensible component of a market-beating investment process is being able to know if you made a mistake. Taking a page from science, we could call this characteristic “mistakability”. A good investing thesis is one that at some point in the future – as result of study and observation – you will be able to know if you were mistaken about, or not.
Speculating per se does not possess this quality. It often relies on nothing more that the notion that something is going up or down and that it will continue to do so. If it does not work out, it is insufficient – at least by the standard I am suggesting – to assert that you made a mistake because it stopped doing so. This is circular logic.
True mistakability is a substantive, positive, assertion grounded in logic and fact. “I think Microsoft’s current software royalties will continue to grow at five to seven percent over the next ten years and that its core software franchise is well protected by a strong moat grounded in high-switching costs and network effects.
If you do not have a clear, written investment thesis for each holding, each of which exhibits mistakability, you may be fooling yourself. If you manage money for others and an investment does not work out, you owe it to your investors to be able to provide a clear explanation of why you invested and what went wrong.
Market-beating investing is predicated on clear, rational thinking and avoiding dumb mistakes. Insisting that your investment theses possess mistakability is essential.