Please note that for the purposes of this analysis, I use the Norman Kemp Smith translation of Immanuel Kant’s Critique of Pure Reason.
The Critique of Pure Reason (German: Critik der reinen Vernunft) by Immanuel Kant, first published in 1781, is one of the most influential works in the history of philosophy, and consequently elevated Kant to be recognized as one of the very greatest Western philosophers ever. Kant began his philosophical works trying to answer the epistemic questions raised by Hume, but in order to do so he changed our conception of knowledge forever, ushering in the modern era of philosophy. Kant’s Copernican insight into cognition and its implications for the justification of objective knowledge and the limits to reason yield many lessons for investors today. These include lessons for the application of valuation and other representative applications, such as modelling, as well as important reminders on the purpose and limits of reason in relationship to knowledge as it pertains to practical activity.
Kant sought to seek an answer to Hume’s skeptical critique of causality and of all scientific knowledge, for without these neither science nor philosophy would be able to claim necessarily true knowledge about reality. Hume had argued that only two kinds of knowledge existed: matters of fact and relations of ideas (see prior analysis: Hume’s An Enquiry Concerning Human Understanding: On Experience). The radical consequences of Hume’s thesis is that principles such as necessary connection are illusory, thereby rendering science and philosophy unable to claim to have objective knowledge. Thus, the question for Kant became, “How are a priori synthetic judgments possible?” (Introduction, B 19). Kant’s greatest innovation was the addition of the category of synthetic a priori knowledge to the existing categories of analytic a priori knowledge (Hume’s relations of ideas) and synthetic a posteriori knowledge (Hume’s matters of fact). For investors, the analogous conclusion is that there are not only definitional truths and empirical facts, but that conceptual knowledge can also be justified. Such a modes of knowledge comprise our intuitions and concepts that we apply to experience – the principles of valuation and economics, relationships of ideas, propositions of causality, among others, that we can make and apply in the art of investing.
Kant called this discovery his ‘Copernican revolution’. Instead of positing that our cognition conforms to the objects of experience, Kant posited that objects of experience conform to our cognition – that is, the mind’s cognitive apparatus has a means of handling experience that intrinsically imposes a structure on all of our experience. Kant agreed with the empiricists, like Hume, that all knowledge begins with experience, thereby rejecting Descartes’ theory of innate ideas. But, Kant asserts, that fact need not mean that all knowledge derives from experience. Kant called this the transcendental activity of the mind – the pre-structuring of experience by the mind. In other words, what we experience is already composed of (i) the independent sensations of objects in the external world, and (ii) the active organization imposed on sensible appearance by the faculties of cognition – namely, intuition. Kant’s thesis overturned millennia of philosophical thought dating back to Plato’s Theaetetus that believed that the mind was a passive and objective recipient of sensible information. Instead, the mind actively grasps and structures our experiences – it constructs the world of our experience. The implications of this have had a far reaching ripple effect on the sciences.
For Kant, the cognitive faculty of our mind is composed of intuition (or sensibility), understanding (or the relations of concepts), and reason (or the ideals of the understanding). As Kant says, “all human knowledge begins with intuitions [of sensibility], proceeds from thence to concepts [of understanding], and ends with ideas [of reason]” (Transcendental Dialectic, A 702 / B 730). Intuition is the immediate representation of experience. Pure intuition – ‘pure’ meaning that it is a priori (hence, non-empirical) – is comprised solely as space and time. Kant writes:
“Time and space, taken together, are the pure forms of all sensible intuition, and so are what make a priori synthetic propositions possible. But these a priori sources of knowledge, being merely conditions of our sensibility, just by this very fact determine their own limits, namely, that they apply to objects only in so far as objects are viewed as appearances, and do not present things as they are in themselves. This is the sole field of their validity; should we pass beyond it, no objective use can be made of them. This ideality of space and time leaves, however, the certainty of empirical knowledge unaffected, for we are equally sure of it” (Transcendental Aesthetic, B 56).
Kant answers Hume’s skepticism of reality by positing that we intuit space and time in experience – that our cognitive faculties structure sensory experience into space and time (in other words, space and time are not external to us, metaphysically speaking). With this proposition, Kant is able to argue that objective knowledge and necessary connection (among other things) are possible because they are synthetic a priori derivatives stemming from space and time (the explanation of which is unnecessary to include in this analysis), thereby refuting Hume’s thesis about habit (see prior analysis: Hume’s An Enquiry Concerning Human Understanding: On Custom). But, there is a price to be paid for this discovery, as Kant points out. One of the consequences of his Copernican revolution is that all of our knowledge is necessarily limited to the bounds of possible experience. For investors today, Kant’s thesis bears on the overextension of reason, especially in the practical activities of valuation or modelling.
It is only the objects of possible experience that our sensible intuition and categories of the understanding can apply to, and of these objects we can say that we have objective pure knowledge. But, for things independent of experience – ‘the thing-in-itself’ – we cannot know. In other words, we have object knowledge of the world as it appears and we have no knowledge whatsoever of things-in-themselves – the object behind or beyond the appearance. But the synthetic a priori knowledge of the intuition (namely, space and time) allows us to know that the thing-in-itself exists because it is held by Kant to be the cause of that which appears to us. As Kant states:
“I do not mean to say that these objects are a mere illusion. For in an appearance the objects, may even the properties that we ascribe to them, are always regarded as something actually given. Since, however, in the relation of the given object to the subject, such properties depend upon the mode of intuition of the subject, the object as appearance it to be distinguished from itself as object in itself” (Transcendental Aesthetic, B 69).
Kant affirms that we have objective knowledge about the objects of our experience as they appear to us, but when we are not observing them, we cannot have knowledge of them. Moreover, as a thing-in-itself, independent of our experience, we also have no knowledge. I believe an apposite analogy for investing is the art of valuation and modelling (whether it be for operations, valuation, or other purposes, such as monetary policy). We may say that we have objective assessment of the value of an enterprise as it appears to us when we model it, but we will never truly know the actual intrinsic value of the enterprise. Our valuations and models, if prudently done, give us an approximation of the appearance of the intrinsic value of an enterprise based on a number of objective factors, but we can never exactly model or value the enterprise as a thing-in-itself because it is beyond our cognitive capacity and reason. Put more simply, valuations or models never 100% accurate, therefore they cannot be the thing-in-itself. That does not mean that our valuations or models are mere illusion, for they have justification through the intuition and concepts that underlying their ability to approximate the enterprise. However, it is that we rely on the appearance of the enterprise as it exists to us, which is typically in the language of financial statements (for the investor), to allow us to intuit the enterprise – but we cannot get behind or beyond this medium to see the value of the enterprise as a thing-in-itself as the medium is inherently limited.
This point is worth more elaboration. We speak of intrinsic value quite casually, saying ‘Company X has an intrinsic value of such-and-such’ and ‘the intrinsic value of this stock is such-and-such per share’. We interpret – or better, translate – the intrinsic value of an enterprise into a quantifying expression (e.g., its enterprise value, dollar value per share, etc.). What we are really measuring – or attempting to measure – is the value of the thing itself, but we only know how to do so by relating it to that a reasonable businessman would pay for it. However, such a definition is relative, not intrinsic because it depends on the opinion of this mythical reasonable businessman – a metaphor that does not exist in reality (i.e., there is no single reasonable businessman who confirms our valuation, and certainly not from Omaha). What we mean when we say intrinsic value is the internal features of the business – its assets and/or competitive advantages – that is causally responsible for the cash flow generating ability of the enterprise.
However, our limited cognitive abilities do not allow us to grasp the intrinsic value of a business by looking at its assets or describing its competitive advantages, we need them to be made intelligible to us through the medium of financial statements and ratios. Like Kant’s theory of cognition, we know that the thing-in-itself (i.e., the enterprise in itself – its assets and competitive features) exist because it is causally responsible for the appearances of which we base our valuations on, namely, that of financial statements and ratios. But, we cannot know the thing-in-itself, the intrinsic value of the business, because we require the medium to understand it and make it intelligible. We don’t even perceive the assets and competitive advantages of the business, except through this medium (i.e., we do not epistemically know if a business has a competitive advantage unless we can translate it into this medium whereby the firm generates more returns than its cost of capital). Valuation is inherently imprecise; there is no magic formula. We speak of valuation the same way we speak of intrinsic value, except we use all kinds of methodologies with more or less equal validity, from our perspective. All-in-all, this affirms the axiom that there is no natural law of valuation (i.e., there is no a priori universal law mandating valuation be done in such-and-such a way). Ergo, valuation is at its deepest core relative, from our perspective, because we can never know the intrinsic value as a thing-in-itself because we do not have the requisite epistemic access to do so, yet nonetheless we believe in things as having an intrinsic value. Ultimately, prudent investors recognize this and do their best to conservatively create their best estimate of the intrinsic value, yet remaining humble in knowing that they can always be wrong.
Perhaps a milder version of this analogy would be the price-value discrepancy. Where price is an objective assessment of the enterprise, is nonetheless an appearance and not the thing-in-itself. While the price is no less tangible, it is not the intrinsic value but the mere appearance of it. The thing-in-itself is the intrinsic value, which we can never know with certainty because our cognitive capacity and tools of reason limit us. Moreover, the thing-in-itself, the intrinsic value, is unobservable. It can only be approximated by the investor through the appearance of the enterprise. Academics and speculators often confuse these aspects, believing that price can move beyond appearance and represent value, or worse, that price and value are synonymous. Part of this fallacy rests on the misunderstanding of ‘real’ with ‘true’; although prices are real, they does not imply that they are true. Reality, if we listen to Kant, is determined by the objective mode of knowledge we can have by observing it. Truth, on the other hand, is an assessment by the limited faculty of reason on the understanding, which is prone to error, as we will see.
For Kant, knowledge is made possible by both intuition and the understanding (which is responsible for the ‘spontaneity of concepts’, as referenced in the following passage). Reason, like intuition and the understanding, is a cognitive faculty of the mind, but does not operate in the enablement of knowledge in the way that the latter do. Kant writes:
“Our knowledge springs from two fundamental sources of the mind; the first is the capacity of receiving representations (receptivity for impressions), the second is the power of knowing an object through these representations (spontaneity [in the production] of concepts… Intuition and concepts constitute, therefore, the elements of our knowledge, so that neither concepts without an intuition in some way corresponding to them, nor intuition without concepts, can yield knowledge” (Transcendental Logic, A 50 / B 74).
Reason, on the other hand, acts upon the understanding to form the principles of our knowledge, in other words, its applications and extension. One may think of the understanding as “a faculty which secured the unity of appearances by means of rules, and reason as being the faculty which secured the unity of rules of understanding under principles” (Transcendental Dialectic, B 359). Accordingly, the understanding generates the concepts from appearances while reason creates principles out of these concepts. Herein lies the problem for Kant: reason, despite its conventional association with rationality, is actually quite speculative if left unchecked. This notion will not likely surprise many investors who only have to look at the ‘hyper-rational’ types that occupy the Federal Reserve and academia, who place 100% faith in their models – the mere appearances of appearances. These individuals pushed the bounds of reason beyond its limits – and it does have limits, as Kant adamantly affirms – to engage and justify a number of speculative theories, such as quantitative easing, strong market efficiency, among other excessive formulations.
Kant’s Critique of Pure Reason, after all, is indeed a critique of pure reason – the kind of reason that gives a priori principles, as distinguished from ‘practical reason,’ which is concerned with the performance of actions. “[Pure] reason”, Kant writes, “has this peculiar fate that in one species of its knowledge it is burdened by questions which, as prescribed by the very nature of reason itself, it is not able to ignore, it is also not able to answer” (Preface, A vii). It is the nature of reason to endlessly seek answers, thereby engaging in the activity of the ascription of principles to knowledge. Kant elaborates:
“[Pure reason] begins with principles which it has no option save to employ in the course of experience, and which this experience at the same time abundantly justifies it in using. Rising with their aid… to ever higher, even more remote, conditions, it soon becomes aware that in this way… its work must always remain incomplete; and it therefore finds itself compelled to resort to principles which overstep all possible empirical employment, and which yet seem so unobjectionable that even ordinary consciousness readily accepts them. But by this procedure human reason precipitates itself into darkness and contradictions” (Preface, A viii).
Kant concludes that reason, when left unchecked, ventures from beyond the empirical to the highly theoretical, ultimately concluding in the most speculative endeavors, such as metaphysics. Much of the same can be said of the anti-empirical approach taken by the academic economists of the Federal Reserve, whose highly theoretical approach has led to the most pernicious and speculative policies. To such speculative endeavors, characteristic of ‘pure reason’, Kant writes:
“It is, indeed, the common fate of human reason to complete its speculative structures as speedily as may be, and only afterwards to enquire whether the foundations are reliable. All sorts of excuses will be then appeal to, in order to reassure us of their solidity, or rather indeed to enable us to dispense altogether with so late and so dangerous an enquiry” (Introduction, B 9).
“For human reason, without being moved merely by the idle desire for extent and variety of knowledge, proceeds impetuously, driven on by an inward need, to questions such as cannot be answered by any empirical employment of reason, or by principles thence derived. Thus in all men, as soon as their reason has become ripe for speculation, there has always existed and will always continue to exist some kind of metaphysics” (Introduction, B 21).
Pure reason’s counter-intuitive nature, that is, its speculative as opposed to rational nature, has the counter-intuitive results of promoting impetuous actions as opposed to prudent deliberation. However, the proponents of pure reason, do not see the counter-intuitive result, thereby perceiving their actions as rational and prudent. Hence, they dogmatically defend their actions so as to dispense with disagreements. The academic economists of the Federal Reserve can be said to be doing much of the same; for they do not know the proper limits of reason. Investors would be prudent to learn this lesson when it comes to their own affairs, valuations and otherwise.