Please note that for the purposes of this analysis, I use the Norman Kemp Smith translation of Immanuel Kant’s Critique of Pure Reason. Please refer to previous analysis which I build upon.
Kant believed that our knowledge rested upon the sensibility of intuition and the concepts of the understanding. However, Kant outlines three faculties of our cognition: intuition, understanding, and reason. The latter, reason, is an ancillary apparatus to our knowledge; it allows us to take our knowledge from the bounds of possible experience and create ideas from it. For Kant, it is the nature of human reason to try to know everything, to push the bounds of knowledge as far as it can go. Specifically, reason posits certain ultimate ideals – it tries to find total unity and causes for the world of experience. However, Kant is critical of reason when it tries to know all or the end. Such enquiry is beyond the capability of human understanding because of the limits of sensible intuition to only possible experience. Reason in its regulatory employment has a beneficial effect for scientific enquiry as it sets the proper bounds to knowledge by its logical limits of understanding. Kant’s analysis of reason – pure reason, in particular – has important and counterintuitive conclusions for investors today. Kant reveals to us that reason is actually the source of pernicious speculation when it is not properly limited; lessons lost on the academic economists, efficient market hypothesizers and Federal Reserve banksters alike, as well as those wayward individuals on fool’s’ quest for a magic formula for investing.
Pure reason, according to Kant, is the speculative form of reason based on a priori principles that provides a unifying ground of the manifold of experience. In other words, we have objective knowledge of the world through our understanding of sensible intuition. However, our understanding is limited and cannot provide a complete phenomenological account of our experience. Pure reason creates ideas that unify the dispersed concepts stemming from the manifold of experience, typically in the form of general principles. As Kant writes:
“For our reason is itself, subjectively, a system, through in its pure employment, by means of mere concepts, it is no more than a system whereby our investigations can be conducted in accordance with principles of unity, the material being provided by experience alone” (The Discipline of Pure Reason, A 738 / B 766).
“[Reason’s] function is to assist the understanding by means of ideas, in those cases in which the understanding cannot by itself establish rules, and at the same time to give to the numerous and diverse rules of the understanding unity or system under a single principle, and thus to secure coherence in every way possible… without reference to any such special interest of reason” (Transcendental Dialectic, A 648 / B 676).
Reason only creates ideas to systematize the material provided by experience, Kant asserts. As such, “Reason is never in immediate relation to an object, but only to the understanding… It does not, therefore, create concepts (of objects) but only orders them, and gives them unity” (Transcendental Dialectic, A 643 / B 671). Thus, we can infer that the role of reason is to assist the understanding; the understanding gives us many concepts from the objects of experience, and reason’s job is to assist the understanding in unifying these concepts under general principles, which Kant calls ideas, where applicable. Similarly for investors, reason is the faculty that unifies the knowledge acquired from experience to form one’s investment principles, down to each individual investment thesis.
The upshot to these statements is that “all those conclusions of ours which profess to lead us beyond the field of possible experience are deceptive and without foundation” (Transcendental Dialectic, A 642 / B 670). When reason goes beyond its proper role in assisting the understanding, it leads to speculation. This is the case because pure reason – reason detached from sensible experience (which is the only things we have objective knowledge about) – tries to create ideas without any valid foundation as our knowledge is limited to the bounds of possible experience. Following Kant’s analogy, without any material to work with, pure reason has no anchor or objective set of premises, hence any conclusions are only speculation. Thus, Kant reaches a rather counter-intuitive conclusion: unrestrained reason, rather than leading to rational decision-making as has been assumed since Plato, leads to wild speculation. While seemingly surprising, prudent investors ought not to be surprised. Investing has always been a practical affair. While reason certainly has an important role in checking the emotions, reason departed from empirical grounds of businesses and people has always belonged to the speculation of academics, where reality consists in merely data points and formulas.
The speculative nature of pure reason rests on its epistemic foundations, or lack thereof. “We cannot employ an a priori concept with any certain without having first given a transcendental deduction of it”, Kant asserts, hence “The ideas of pure reason do not, indeed, admit of the kind of deduction that is possible in the case of categories [of understanding]” (Transcendental Dialectic, A 669 / B 697). In other words, pure reason does not rest on the same epistemic ground of justification as the understanding. This has a twofold implication. First, the material provided by the understanding, to continue Kant’s metaphor, has priority over reason. Pure reason generates ideas alone. Ideas alone cannot form the basis of any objective judgment about reality. Instead, ideas rest on the validity of the concepts of the understanding, which Kant asserts we know objectively because it can be deduced a priori. Secondly, the ideas of pure reason ought to conform to reality, but not the reverse. Prudent investors, for example, check their theses against precedents and assess the feasibility of their key assumptions. This is to say that investors justify their theses on the bounds of possible experience, that is, they shape their theory to reality. Contra investors, the academic economists and quants shape reality to their theories. When the fallacious formulas are empirically disproven, these frauds assert that the error lies in reality, not in their reason. Instead, with great impetuosity they fool themselves into adding more factors to their model. For what is a small-cap risk premium? If it were truly riskier, then why does this ‘phenomena’ still exist?
Furthermore, Kant calls into question the grounds of pure reason. By what right, Kant asks, permits reason treat the multiplicity of reality as a disguised unity? In other words, without an a priori deduction of its own, reason begs the question by presupposes what it seeks to find; namely, that there a unity in nature. Therefore, reason, which accounts for our active drive for the acquisition of knowledge, rests upon a questionable foundation, as Kant states:
“For with what right can reason, in its logical employment, call upon us to treat the multiplicity of powers exhibited in nature as simply a disguised unity, and derive this unity[?]…The law of reason which requires us to seek for this unity, is a necessary law, since without it we should have no reason at all, and without reason no coherent employment of the understanding, and in absence of this no sufficient criterion of empirical truth” (Transcendental Dialectic, A 651 / B 679).
However, Kant states, we must presuppose this law of reason, as he calls it, as it is necessary because without it we would have no need for reason at all. Ergo, we would not be able to obtain any coherence from the understanding without the drive to do so in the first place, whether it was founded or not. But on the other hand, because of the shaky epistemic foundations of reason, it is important to keep reason within the bounds of possible experience so as to avoid speculation. This means that reason must be adhered to the bounds of possible experience, thereby tested against empirical evidence, so as to avoid speculation. Value investing, ever a practical affair, is empirically shown to outperform all other forms of speculation in the long-run. Efficient markets and all other magic formulas, on the other hand, have not withstood the test of time.
Reason does have a necessary role in regulating the understanding. Through the desire for and the creation of ideas, reason directs the understanding to strive for certain goals of knowledge, namely that of general principles which unify the disparate concepts of the understanding. In this role, reason gives the understanding the greatest unity (through the general principles) and extension (by the desire to create new principles), as Kant writes:
“[Transcendental Ideas of Pure Reason] have an excellent, and indeed indispensably necessary, regulative employment, namely, that of directing the understanding towards a certain goal upon which the routes marked out by all its rules converge, as upon their point of intersection… it serves to give these concepts the greatest [possible] unity combined with the greatest [possible] extension” (Transcendental Dialectic, A 644 / B 672).
“where the limits of our possible knowledge are very narrow, where the temptation to judge is great, where the illusion that besets us is very deceptive and the harm that results from the error is considerable, there the negative instruction, which serves solely to guard us from errors, has even more importance than any piece of positive information which our knowledge is increased” (The Discipline of Pure Reason, A 709 / B 737).
The regulative role of reason is violated when reason drives us to judge beyond the limits of our possible knowledge, hence speculation. Reason should have a negative purpose, that is, for the falsification of speculative ideas, which guards us from errors. Kant is particularly worried about the deleterious effects of errors for he views the history of metaphysics as a myriad of errors. These errors, speculative theories, ripple through history, deceiving minds into chasing these bankrupt enterprises, thereby retarding the progress of objective knowledge. Similarly, how much time and effort has been wasted debating theories of market efficiency? How much industry has been expended to refine the discounted cash flow approach? Such expenditures have increased its precision, but all for the reward of being precisely wrong! For the future is uncertain, thus the astute investor realizes it is more beneficial to be generally accurate.
Pure reason’s speculative inclination is most rabid in those who seek the intelligibility of the multiplicity of experience. Kant writes, “Those who are more especially speculative are, we may almost say, hostile to heterogeneity, and are always on the watch for the unity of the genus” (Transcendental Dialectic, A 655 / B 683). These types, the academic economists first among them, are so audacious in their quest for a single set of formula to explain human activity. They say that there must be a single, rational principle that explains all human behavior. But they are wrong! There are many people with even more interests, no principle can generalize their behavior, let alone account for the institutional and structural effects of markets. Hence, reality is a multiplicity, most of which is unintelligible. On these speculative types, Kant continues:
“There is no need of a critique of reason in its empirical employment, because in this field its principles are always subject to the test of experience… But where neither empirical nor pure intuition [as is in the case of mathematics] keeps reason to a visible track… it stands so greatly in need of discipline, to restrain its tendency towards extension beyond the narrow limits of possible existence and to guard it against extravagance and error, that the whole philosophy of pure reason has no other than this negative utility” (The Discipline of Pure Reason, A 711 / B 739).
Kant affirms the proper role of reason in its empirical employment as subject to the test of experience and for its negative utility in falsification, while critiquing its speculative inclination to go beyond the limits of possible experience. This lesson seems to be lost on the academic economists of the Federal Reserve, who ignoring the standard of empirical employment, fortify their theories in formulas and other fancy mathematics. Their models are said to be sound based on their ‘intuition’ – or dogmatism, if you prefer. Moreover, Kant would be highly skeptical of the valid of such ‘intuition,’ for he believed that reason ought to be anchored by experience:
“pure philosophy is at sea when it seeks through a priori discursive concepts to obtain insight in regards to the natural world, being unable to intuit a priori (and thereby to confirm) their reality… unconsciously, they pass from the field of sensibility to the precarious ground of pure and even transcendental concepts, a ground that permits them neither to stand nor to swim, and where their hasty tracks are soon obliterated” (The Discipline of Pure Reason, A 725-6 / B 753-4).
Without the anchor of experience, pure reason finds itself at sea without a compass. It enters the completely speculative realm where any idea goes because there is nothing to disprove them except ideas themselves. Hence, Kant emphasizes the necessity of limiting pure reason to its negative utility, which is its regulatory role. Similarly, the Federal Reserve banksters, instead of speculative ‘trickle-up’ effect of printing money, ought to have looked to back in their histories and they would have seen the successful monetary policy during the forgotten depression of 1921.
Kant spends much of the latter half of the Critique discussing why philosophy cannot emulate mathematics in the application of pure reason. Mathematics, Kant asserts, is derived a priori, independent of experience. Philosophy, contra mathematics, cannot have the exactness of definitions, axioms or demonstrations. All philosophical concepts must be ultimately based on a posteriori, experienced intuition. This is different from algebra and geometry, which use concepts that are derived from a priori intuitions, such as symbolic equations and spatial figures. With this in mind, Kant writes:
“We have made it our duty to determine, with exactitude and certainty, the limits of pure reason in its transcendental employment. But the pursuit of such transcendental knowledge has this particularity, that in spite of the plainest and most urgent warnings men still allow themselves to be deluded by false hopes, and therefore to postpone the total abandonment of all proposed attempts to advance beyond the bounds of experience into the enticing regions of the intellectual world. It therefore becomes necessary to cut away the last anchor of these fantastic hopes, that is, to show that the pursuit of the mathematical method cannot be of the least advantage in this kind of knowledge (unless it be in exhibiting more plainly the limitations of this method); and that mathematics and philosophy, although in natural science they do, indeed, go hand in hand, are nonetheless so completely different, that the procedure of the one can never be imitated by the other” (The Discipline of Pure Reason, A 726 / B 754).
The coda to Kant’s assessment is that philosophy cannot possess dogmatic certainty because of the limitation of reason in its field. For Kant, the limits of reason lie in the field of experience as, after all, all knowledge depends on experience. According to Kant, a dogmatic statement would be a statement that reason accepts as true even though it goes beyond the bounds of experience. This conclusion follows for investing and economics. Academic economists, and some investors, forget that financial markets and investing, are not governed by physics or mathematics. The academic economists, in particular, insecure with their status as a ‘soft science’ resort to building fortresses of formulas and factor-models to hide behind. When their extraordinary actions are challenged by the common sense individual, they resort to the most elitist dogmatism – gussying up their thoughts so as to deter questioning from all non-Ph.Ds. and all others foreign to the tongue of econometrics. To this, Kant would reply:
“Reason must in all its undertakings subject itself to criticism; should it limit freedom of criticism by any prohibition, it must harm itself, drawing upon itself a damaging suspicion. Nothing is so important through its usefulness, nothing so sacred, that it may be exempted from this searching examination, which knows no respect for persons. Reason depends on this freedom for its very existence. For reason has no dictatorial authority; its verdict is always the agreement of free citizens, of whom each one must be permitted to express without let or hindrance, his objections or even his veto” (The Discipline of Pure Reason, A 738-9 / B 766-7).
Kant concludes that when reason goes beyond its own limits, it becomes dogmatic. Philosophy cannot emulate mathematics, nor should it. Philosophy’s true purpose lies in its practical relationship to experience, in removing illusions and clarifying concepts. Kant concludes:
“From all this it follows that it is not in keeping with the nature of philosophy, especially in the field of pure reason, to take pride in a dogmatic procedure, and to deck itself out with the title and insignia of mathematics, to whose ranks it does not belong, though it has every ground to hope for a sisterly union with it. Such pretensions are idle claims which can never be satisfied, and indeed must divert philosophy from its true purpose, namely, to expose the illusions of a reason that forgets its limits, and by sufficiently clarifying our concepts to recall it from its presumptuous speculative pursuits to modest but thorough self-knowledge” (The Discipline of Pure Reason, A 735 / B 763).
Philosophy exists because pure reason is limited, Kant concludes: “Indeed it is precisely in knowing its limits that philosophy exists” (The Discipline of Pure Reason, A 727 / B 755). Understanding the limits of knowledge is the practical endeavor of reason. The link between philosophy here and investing is one of deep lineage, and thus it is not surprising that investing in its genuine and original sense, what is referred to today as value investing, is based on the same principle of the understanding and respect of the limits of reason. Just as pure reason is employed in philosophy for its negative utility, prudent investors use reason because investing is not a science and investment theses can never be proven, only falsified. Thus, reason is the investor’s guide to avoid losses by falsifying those theses that go beyond the bounds of sensible experience, but reason errs when it is used for speculative theory building for the sake of chasing returns.
I conclude with the apt words of Nobel Laureate economist George Stigler of the University of Chicago, who as such, had first row seats to the degeneration of the art of economics:
“Less than a century ago a treatise on economics began with a sentence such as, ‘Economics is a study of mankind in the ordinary business of life.’ Today it will often begin: ‘This unavoidably lengthy treatise is devoted to an examination of an economy in which the second derivatives of the utility function possess a finite number of discontinuities. To keep the problem manageable, I assume that each individual consumes only two goods, and dies after one Robertsonian week. Only elementary mathematical tools such as topology will be employed, incessantly.’”