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Cutting Through Assumptions

Occam's Razor principle can be applied to judging the risk level of an investment portfolio. Investments that require fewer unproven assumptions are less risky

Ockham's Razor is a principle commonly attributed to a man named William of Ockham, an English monk who lived in the 14th century. William was a philosopher and a logician and his principle states that when multiple explanations are available for a phenomenon, the simplest version is likeliest to be the correct one. While that sounds logical, it immediately raises the question of judging which of the explanations is the simplest. This is actually the more interesting part.

The simplest explanation in Ockham's Razor (or Occam-there are several spellings) is the one which requires the least number of unproven assumptions. Think about that. It sounds simple and it is, but it's a profound kind of simplicity. Here's the example that is often given while explaining Ockham's Razor. You are walking in a forest and come up on a tree that has burnt down. Which explanation is more likely, that the tree was struck by lightning, or that aliens from a planet many light years away came to earth and burnt down the tree?

The lightning explanation requires the assumption that trees can be struck by lightning, which is not an assumption at all, but a known fact. The aliens explanation requires the unproven assumptions that there are aliens, and that they come to earth and that for some reason, they choose to stay hidden and burn down trees.

Ockham's Razor has been used in many fields. In scientific research, it is a basic principle but it is important to note that Ockham's Razor does not necessarily give the right answer. It is, instead, a loose guide to choosing that hypothesis which contains the smallest number of unproven assumptions.

I find that a variation of Occam's Razor can be applied to judging the risk level of an investment portfolio. Investments that require fewer unproven assumptions are less risky. Consider this: is an investment in a diversified equity fund likelier to gain over the next five years than one in a sector fund? It doesn't require too much thought to see that getting returns in a particular sector requires an unproven assumption-that that particular sector is going to gain over the next five years. Getting gains from the diversified fund needs the assumption that at least some sectors will do well over the next five years. While this assumption cannot be 'proven'-unlike the physical sciences, things cannot be 'proven' in investing-it is much closer to being proven.

I find that almost any investment question can be restated in terms of proven and unproven assumptions. I am not saying that Ockham's Razor is the right way to decide about investments. Instead, I find that it's a useful tool to clarify the actual nature of some problems. For example, think of the most common question that any investor asks today, whether one should invest in the stock markets at today's levels. By itself, it's an unanswerable question and any answer is a guess. Try and shave this question with Ockham's Razor but don't just count the external assumptions. Instead, make a list of all assumptions including those relating to your personal financial situation. You may just find that by squaring off your personal assumptions against those of the market, you can come up with the right answer.

By the way, if you are wondering why is Ockham's Razor called a razor, don't ask me because I don-t know either.