Please note that for the purposes of this analysis, I use the Eric Steinberg edition of Hume’s An Enquiry Concerning Human Understanding. Please refer to a previous analysis of Hume’s An Enquiry.
Hume criticized the ethical/moral philosophy as well as the rationalist camp of philosophy. He sought to reform philosophy to be more naturalist, thereby making it more scientific and respectable. Hume thought that philosophy ought to observe what really occurs in the real world. In order to achieve this end, Hume sought to develop empirically-driven description of the human mind and how it works. In his analysis of human understanding, he delineated what he argued that knowledge could belong to only two categories, one of which was a priori and the other being solely from experience. Hume deemed that this delineation was his greatest contribution to philosophy. For investors, Hume’s analysis of experience provides valuable insights into human cognition and its biases. Armed with this lesson, a prudent investor will be better prepared to guard against fallacious assumptions and should be cautious in gauging their margin of safety.
Hume begins by drawing a distinction between ‘relations of ideas’ and ‘matters of fact.’ This is one of the first formulations of a distinction of knowledge that has been instrumental in philosophy ever since. Hume writes:
“All the objects of human reason or enquiry may naturally be divided into two kinds, to wit, Relations of Ideas, and Matters of Fact. Of the first kind are the sciences of Geometry, Algebra, and Arithmetic; and in short, every affirmation, which is either intuitively or demonstratively certain. ‘That the square of the hypotenuse is equal to the square of the two sides,’ is a proposition, which expresses a relation between these figures. Propositions of this kind are discoverable by the mere operation of thought, without dependence on what is anywhere existent in the universe” (Section IV, Part I).
Relations of ideas are quite easily discernable to Hume. This is what Kant would effectively call analytic a priori truths; propositions that possess indestructible bonds created between ideas that are predicated within the proposition itself. For example, it is necessarily true that ‘all bachelors are unmarried’ and that ‘triangles have three sides.’ One cannot conceive of a triangle without three sides, any attempt to would either destroy the concept of a triangle or would merely be referring to a rectangle, pentagon, etc. Therefore, relations of ideas are intuitively or demonstrably certain, and a denial of such a proposition implies a contradiction. I posit that relations of ideas are rarely encountered, if at all, in investing. Perhaps the only relation of ideas of importance is the concept of risk and its a priori relationship to returns and margin of safety, but such is a topic for a different analysis.
Next, Hume turns our attention to the all-important ‘matters of fact.’ Unlike ‘relations of ideas,’ this category of knowledge is not a linguistic contraption, but is a matter of observation and experience. Hume states:
“Matters of fact, which are the second objects of human reason, are not ascertained in the same manner; nor is our evidence of their truth, however great, of a like nature with the foregoing. The contrary of every matter of fact is still possible; because it can never imply contradiction, and is conceived by the mind with the same facility and distinctness, as if ever so comfortable to reality. ‘That the sun will not rise to-morrow’ is no less intelligible a proposition, and implies no more contradiction, than the affirmation, ‘that it will rise.’ Were it demonstratively false, it would imply a contradiction, and could never be distinctly conceived by the mind” (Section IV, Part I).
Matters of fact deal with experience: both ‘the sun is shining’ and ‘tomorrow I will go for a walk’ are matters of fact. They are learned a posteriori, and can be denied without fear of contradiction. If it is sunny outside and I assert that it is raining, I can only be proven wrong by looking out the window and checking: my assertion cannot be disproved simply by an appeal to logic and reason. Similarly, Hume says ‘that the sun will not rise tomorrow’ is no less contradictory than ‘the sun will rise tomorrow.’ While this assertion seems intuitively false, Hume’s point is that in either case we need to refer to the world around us to verify either statement. For investors, most knowledge one obtains is matters of fact. Both company and industry knowledge, as well as claims about the future, can only be (dis)proven from observation. There is no necessary logical basis for such knowledge. Therefore, understanding the cognitive process by which we obtain said information is of paramount importance.
Hume asserts that ‘cause and effect’ is the line of reasoning, if it can be called that, which makes us inclined to believe that which cannot be directly verified. For example, if one finds a manmade artifact on a deserted island, one concludes that a man must have been on that island sometime in the past. Hume writes:
“A man, finding a watch or any other machine in a desert island, would conclude, that there had once been men in that island. All of our reasonings concerning fact are of the same nature. And here it is constantly supposed, that there is a connexion between the present fact and that which is inferred from it… Why? because these are the effects of the human make and fabric, and closely connected with it. If we anatomize all the other reasonings of this nature, we shall find, that they are founded on the relation of cause and effect” (Section IV, Part I).
Hume posits that from cause and effect we infer that there is some connection. We have some notion of a relationship between the artifact and man, and then we infer that it the man is the cause and the presence of the artifact is the effect. Similarly as investors, one often sees a company announce a strategy, which now becomes the cause of all future effects. Hence, in viewing future financial statements one infers that these are the effects to which the strategy is the cause; but as Hume will argues, this is just an illusion.
Hume then asks how we know the principle of cause and effect. He suggests that causal knowledge cannot be a priori, since it can be denied like ‘matters of fact’ without contradiction. This notion leads Hume to assert:
“I shall venture to affirm, as a general proposition, which admits of no exception, that the knowledge of this relation is not, in any instance, attained by reasoning a priori; but arises entirely from experience, when we find, that any particular objects are constantly conjoined with each other” (Section IV, Part I).
Hume asserts that cause and effect are themselves totally distinct. From this he concludes that our knowledge of cause and effect must be based on experience. From observed phenomena in the past, one infers it to be akin to all similar phenomena in the future. This seemingly obvious cognitive process is something that is all too obvious but nonetheless taken for granted. This is because the fact that inference comes from experience and not a priori knowledge carries a number of consequences with it; namely, these include the problem of induction and issues of selection bias. What Hume teaches investors today is that each situation is its own unique phenomena; cause and effect is the amalgamation, distortion, and over generalization of hundreds – if not thousands – of idiosyncratic initial factors and an equally great number of resulting factors. To assume that one set of observed phenomena will resemble a future phenomena is risky for no two phenomena is ever the same.
The most important upshot that experience (primarily) determines cause and effect. One might object to the notion that cause and effect can be rationally deduced. Hume argues to the contrary as he says that “nor can our reason, unassisted by experience, ever draw any inference concerning real existence and matter of fact” (Section IV, Part I). Rather, Hume says that experience is what informs the mind of the relationship between distinct concepts. Hume states, “nor does any man imagine that the explosion of gunpowder, or the attraction of a loadstone, could ever be discovered by arguments a priori” (Section IV, Part I). He argues that there is no rational basis to believe that gunpowder’s explosive properties is knowable without the knowledge that we know of this connection which comes from experience alone. Given that experience determines our ability to infer cause and effect; this places the impetus on avoiding selection biases when one draws on experience to make claims about the future. For too small a sample size can lead to erroneous causal claims. The lesson here for investors is obvious.
Not only is experience the determinate source of knowledge about cause and effect, Hume goes much rather to argue that knowledge of true cause and effect is actually impossible. Hume establishes that experience does not provide sufficient proof that what we claim to be cause and effect is true. This is because of the problem of induction, which Hume outlined in the general criticism of ‘matters of fact.’ Hume writes:
“The mind can never possibly find the effect in the supposed cause, by the most accurate scrutiny and examination. For the effect is totally different from the cause, and consequently can never be discovered in it. Motion in the second Billiard-ball is quite a distinct event from motion in the first; nor is there anything in the one to suggest the smallest hint of the other” (Section IV, Part I).
Given that it is no more contradictory to deny that the effect will occur without contradiction, then cause and effect are epistemologically distinct. Though not entirely, if at all Hume’s point, I also interpret this to show that in any given scenario, there may be hundreds of mitigating factors and hundreds of equally conceivable scenarios, therefore randomness plays a large role in determining which option is determined to be the outcome. The upshot, something Hume would agree with, is that all cause and effect is arbitrary. It is something we impose on experience, often in the form of grandiose claims, in order to make the unintelligible intelligible. While this conclusion may seem radical, the underlying notion that randomness plays a large role is substantive for philosophies, the sciences, and investing alike.
Up until this point Hume has argued that we base our knowledge of future events in past experience, but how does one know that the past is a good guide for future predictions? Hume argues that we cannot know that the future will resemble the past by means of experience nor by reasoning. Given this shortcoming, which is not new to any prudent investor, Hume provides the following advice:
“Philosophers, that give themselves airs of superior wisdom and sufficiency, have a hard task, when they encounter persons of inquisitive dispositions, who push them from every corner, to which they retreat, and who are sure at last to bring them to some dangerous dilemma. The best expedient to prevent this confusion, is to be modest in our pretensions; and even to discover the difficulty ourselves before it is objected to us. By this means, we may make a kind of merit of our very ignorance” (Section IV, Part II).
Hume argues that man’s understanding is naturally limited by his faculties, and therefore it is impossible to know with certainty that the future will resemble the past. Any claims otherwise are dubious and arrogant, and when pressed by an inquisitive interlocutor, one will find that there is no leg for these ‘matters of fact’ to stand on with certainty. Therefore, the best advice is to be modest in one’s pretensions and assertions. In this way, knowing that one doesn’t know (with certainty) one turns a weakness and liability into a strength and asset.
I argue that Hume provides investors with a philosophical, epistemological justification upon which the prudent rationale is founded. Hume argued that experience based reasoning is subject to the problem of induction. Hume writes:
“We have said, that all arguments concerning existence are founded on the relation of cause and effect; that our knowledge of that relation is derived entirely from experience; and that all our experimental conclusions proceed upon the supposition, that the future will be conformable to the past. To endeavor, therefore, the proof of this last supposition by probable arguments, or arguments regarding existence, must be evidently going in a circle, and taking that for granted, which is the very point in question” (Section IV, Part II).
Hume argues that experience based arguments beg the question, that is, they assume that which they are trying to prove. Experience based reasoning implicitly assumes that in order to establish comparisons or cause and effect, one must assume that the future will resemble the past. One can only know that the future will resemble the past through experience. Moreover, one cannot say with assurance that the future will always resemble the past, viz. experience, because it only takes one instance of the contrary to disprove the supposed connection. Therefore, Hume implies that there is no justifiable proof that experience will be correct because of this problem of induction. Therefore, experience-based arguments ought to be reasoned with and viewed skeptically. That is not to say that they ought to be discarded, for experience is a better guide than no evidence. However, a great investor will not accept past experience as sole justification for future phenomena, instead the great investor views each situation and scenario independently and with an unbiased gaze, and will judge the relevance of past experience and apply it carefully to the situation at hand only after the initial and rigorous diligence.
Hume’s point is not to entirely diminish the role of experience. In fact, Hume does not even argue that experience is intrinsically wrong or anything of the like. Hume even says that “none but a fool or madman will ever pretend to dispute the authority of experience, or to reject that great guide of human life” (Section IV, Part II). Hume’s main point is that experience is certainly fallible, therefore it ought to be used with caution. Hume writes:
“If we be, therefore, engaged by arguments to put trust in past experience, and make it the standard of our future judgment, these arguments must be probably only, or such as regard matter of fact and real existence, according to the division mentioned above. But that there is no argument of this kind, must appear, if our explanation of that species of reasoning be admitted as solid and satisfactory” (Section IV, Part II).
Hume says that if one uses experience as a guide, then it must be employed properly and with prudence. As such, experience should be used either as probabilistic evidence or otherwise be recognized to be fallible (that is, as a matter of fact). Experience-based evidence cannot be considered on its own to be wholly satisfactory. Drawing conclusions from experience presupposes that the future will remain the same; this is a potentially dangerous assumption. As Hume points out, a wise philosopher will make sure to be modest in one’s pretensions. For investors this is a lesson of paramount importance. Past success or failures can color that way one sees subsequent opportunities. One’s inability to truly understand cause and effect in complex systems, such as is the case in the real world, can lure one into a false sense of security when based on experience. As such, experience cannot provide a margin of safety; rather it can only provide a perspective.