Isaac Newton

IFA's Scientific Approach to Investing

Isaac Newton

Since its inception, Index Fund Advisors has always strived to take a scientific or academic approach to investing. We follow the evidence (i.e., long-term returns data) to wherever it leads us and we live by the Latin motto of The Royal Society, “Nullius in Verba”—take no one's word for it. The history of the Royal Society goes back to the 1640s, when philosophers began meetings to discuss the new philosophy of promoting knowledge through observation and experiment, which we now call science

A similar idea was espoused by one of its most illustrious past presidents, Sir Isaac Newton, who in his magnum opus (The Principia) famously said, “Hypotheses non fingo”—I feign no hypothesis. Here is a more detailed explanation by Newton himself from a modern translation of Principia. 

“I have not as yet been able to discover the reason for these properties of gravity from phenomena, and I do not feign hypotheses. For whatever is not deduced from the phenomena must be called a hypothesis; and hypotheses, whether metaphysical or physical, or based on occult qualities, or mechanical, have no place in experimental philosophy. In this philosophy particular propositions are inferred from the phenomena, and afterwards rendered general by induction.”1

Perhaps Newton is best known for his formula that quantifies the gravitational attraction between two bodies based on their masses and distance between them. For Newton, speculating why bodies attract each other rather than repel each other or why they don’t attract each other to a greater degree would have been in the realm of a feigned hypothesis. To see and hear examples of feigned hypotheses regarding investing, one need only watch CNBC for fifteen minutes where the guru du jour will share his “insights” as to why the market (or a particular stock) is “going up” or “going down”. Of course, there will usually be another guru to take the opposite position which keeps us entertained, but certainly not informed. A valid hypothesis can be subjected to statistical testing which will either disprove it or allow it to survive falsification until another hypothesis is formulated that better explains our observations of the data.

Returning to Newton, his first law of motion (that a body at rest tends to stay at rest and a body in motion tends to stay in motion at a constant velocity unless acted upon by an external force) lends insight into the process of modifying investors’ behaviors for their own benefit. We at Index Fund Advisors have witnessed innumerable instances of the destructive impact of inertia on investor returns. When an investor is moving in the wrong direction (or simply not moving at all by having cash on the sideline), it is no easy task to apply the correct amount of force (i.e., education) to get him into a regimen of buying, holding, and rebalancing a risk-appropriate portfolio.

Education is by no means limited to simple conveyance of knowledge, as it entails addressing behavioral tendencies such as overconfidence and anchoring. Newton himself had an almost prophetic insight into the field of behavioral finance centuries before its inception when humorously remarked, “I can calculate the motion of heavenly bodies, but not the madness of people.”2 This quote also reminds us of the very important distinction that while physical systems have laws that remain constant, thereby yielding predictability, markets and economies are not physical systems. Their outcomes are heavily dependent on human behaviors which have no governing equations. Nevertheless, the evolution of our knowledge of how markets work has proceeded apace. The Economist recently published an article4 about the decline of active management that includes a beautifully written explanation of how a large number of institutional investors have come to the realization that Wall Street has made a fortune by packaging up luck and selling it as skill:

"Institutional investors, too, have gradually become more sophisticated about identifying how fund managers generate returns. A hundred years ago they regarded all returns as evidence of a manager’s skill. Then they began to compare returns with those of other managers or the market. Later, with the help of academics, they realised that fund managers might beat the index by taking more risk; so they started to use risk-adjusted measures. Then they realised that outperformance might be down to fashion: the manager might have had a big exposure to, say, value stocks that had been doing well in recent months; so they began to attribute managers’ performance to factors such as cheapness or exposure to smaller companies."

Realizing that factor exposure is the primary determinant of returns rather than security selection, the author of The Economist article draws the inevitable (i.e., scientific) conclusion that investors are better off indexing rather than trying to find a "skilled" manager:

"All this has narrowed the scope for managers to demonstrate skill, rather as Victorians explained more and more natural phenomena in terms of science, rather than divine intervention. Where market returns can be explained by exposure to various factors, those factors can be replicated in the form of ETFs [or index mutual funds] at low cost. And the ETF [or index mutual fund] investor need never worry about the manager losing his mojo or quitting to join another firm."

As we say at the beginning of Step 2 of IFA’s 12-Step Recovery Program for Active Investors, “Investors should defer to the higher knowledge of Nobel Prize Winners.” This does not mean that investors need to comprehend the matrix mathematics behind Modern Portfolio Theory or the stochastic calculus behind the random walk of price movements. The beautiful thing about investing is that you don’t have to be a genius or an expert to do well at it. As Warren Buffett put it, “If calculus or algebra were required to be a great investor, I would have to go back to delivering newspapers.”5  All too often, genius can be an impediment to successful investing, especially when it leads to an illusion of validity or the recognition of patterns that really don’t mean anything. The Oracle of Omaha elucidates it further in his 2013 letter to Berkshire Hathaway shareholders.

“You don’t need to be an expert in order to achieve satisfactory investment returns. But if you aren’t, you must recognize your limitations and follow a course certain to work reasonably well. Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick ‘no.’”

We could not agree more. If you would like to learn more about IFA’s scientific approach to investing, please call us at 888-643-3133.


1Isaac Newton (1726). Philosophiae Naturalis Principia Mathematica, General Scholium. Third edition, page 943 of I. Bernard Cohen and Anne Whitman's 1999 translation, University of California Press ISBN 0-520-08817-4, 974 pages.

2Isaac Newton. BrainyQuote.com. Retrieved May 5, 2014, from BrainyQuote.com Web site: http://www.brainyquote.com/quotes/quotes/i/isaacnewto384639.html

3Newton, Isaac (1848). Newton's Principia. English Translation by Andrew Motte. p. 412.

4http://www.economist.com/news/briefing/21601500-books-and-music-investment-industry-being-squeezed-will-invest-food

5The Tao of Warren Buffett, Simon & Schuster, 2006.