The Deutschian Investor
The Explanatory Approach to Investment
David Deutsch's epistemological framework, focused on explanation and knowledge creation rather than induction from patterns, fundamentally reframes investment decision-making in several important ways.
When we examine market commentary, we encounter explanation-shaped holes rather than genuine knowledge. Consider how analysts retrofit narratives to market movements: "Stocks fell today due to inflation concerns" could easily become "Stocks rose today as investors shrugged off inflation data." These explanations can accommodate any outcome without modification to their core premises… a telltale sign of explanatory emptiness.
The key insight is that explanatory power comes not from being able to predict specific outcomes (which is impossible due to the unpredictability of future knowledge creation), but from identifying structural features that constrain the space of possible outcomes in meaningful ways. A company with genuine competitive advantages has created knowledge that is difficult for competitors to replicate through trivial variations of existing approaches.
Seeking universal formulas for investment success fundamentally misunderstands the nature of markets and financial systems. The quest for deterministic patterns... whether through P/E ratios, growth metrics, or historical performance, represents what we might call "bad philosophy" in the realm of investing. This pattern-seeking behavior fundamentally misunderstands how knowledge advances and how value is created in markets.
Markets aren't mechanical systems that follow rigid laws like planetary orbits. They're complex adaptive systems composed of humans creating and solving problems in open-ended ways. This explains why the top performers of one decade rarely maintain their status in the next... they aren't following universal laws of outperformance, but rather temporarily benefiting from specific explanatory advantages that eventually become obsolete or widely understood. Markets are complex adaptive systems where participants constantly create new knowledge and solutions to problems. This ongoing creation of knowledge makes purely inductive approaches inherently limited. The top performers of the past decade have no special likelihood of outperforming in the next, precisely because outperformance isn't about repeating past patterns… it's about creating new knowledge that solves evolving problems.
Rather than searching for universal formulas, a Deutschian approach to investing centers on developing robust explanatory frameworks. This means first understanding the landscape of human problems and potential solutions. What difficulties are people trying to overcome? What range of approaches might solve these problems? How does a particular company's offering fit within this problem-solution space? Good investing, like good science, isn't about finding infallible algorithms. It's about creating explanations with reach... frameworks that help us understand how businesses create value in dynamic environments. These explanations must address fundamental questions: What problems is this business solving? How defensible are its solutions? What knowledge does the company create and preserve? Why might collective market intelligence be misjudging its prospects?
For any investment candidate, we must develop an explanatory understanding of:
How the business creates genuine value for customers
What makes its approach resilient to competitive and environmental changes
Whether its advantages are defensible and for how long
How effectively its solution can scale to address larger problem spaces
Why the market might be systematically misjudging these factors
This explanatory process is fundamentally critical and fallibilist. Most investment ideas should fail this scrutiny, leading to no action—a feature, not a bug, of sound reasoning. The few ideas that survive rigorous attempts at refutation become the most promising candidates. Even then, certainty remains impossible because future knowledge creation is inherently unpredictable.
This explanatory approach acknowledges what I would call the "Popperian reality" of markets... that our investment theses must be falsifiable and subjected to critical testing. Most investment ideas should fail this scrutiny, which is precisely the point. The few that survive represent situations where we might genuinely understand something the market doesn't yet fully appreciate.
Even then, certainty remains impossible. The future economy emerges from countless human decisions and innovations that cannot be predicted in detail. But good explanations can help us navigate this fundamental uncertainty better than simplistic heuristics or pattern-matching ever could.
True investment wisdom lies not in prediction, but in explanation... developing frameworks that help us understand businesses as evolving problem-solving entities within the broader landscape of human progress. This shifts our focus from short-term price movements to the deeper currents of value creation that ultimately drive long-term returns. It recognizes that stock ownership represents partial ownership of a knowledge-creating entity, not merely a ticker symbol whose price we hope to predict. By adopting this mindset, we approach investment decisions as if we were buying the business for its entire remaining lifespan, focusing on its capacity to continue solving problems and creating value through ongoing knowledge creation.
The Deutschian investor embraces uncertainty not as something to minimize through more data or better formulas, but as an inevitable consequence of the open-ended nature of knowledge creation. Better explanations lead to better decisions, but the future remains unpredictable precisely because tomorrow's knowledge cannot be derived from today's.
Finding genuine explanatory power amid market noise requires a conceptual revolution in our thinking about investments. The conventional approach… predicting precise outcomes in complex systems is fundamentally misguided. What matters instead is the search for hard-to-vary explanations that capture the underlying reality of businesses and their competitive positions.
What constitutes a good explanation for investment value? It must identify the specific problem-solution space a company occupies, the epistemological advantages it has developed, and why these advantages resist easy replication. The explanation must constrain reality… it must rule out certain outcomes rather than accommodate any possible future.
Integrated solution providers are particularly interesting from this perspective. They often appear messy and unpredictable precisely because they're engaged in genuine knowledge creation… solving problems through conjecture and refutation rather than following a linear, predetermined path. Their processes reflect the fundamental structure of knowledge creation itself: problems spawn solutions which spawn new problems in an endless progression.
To understand the exceptional durability of certain businesses, we must examine the explanatory depth behind their competitive advantages. What separates truly resilient companies from the merely successful is not simply the presence of a moat, but the explanatory power behind how that moat was constructed.
The most formidable companies have devoted themselves to creating capabilities that solve genuinely hard problems… problems that contain intrinsic complexity resistant to easy imitation. These solutions aren't merely complicated; they represent knowledge that transforms what was previously impossible to solve into something tractable.
Consider what happens when a company develops an integrated system of solutions, each component precisely calibrated to work with others. This isn't mere synergy in the trivial business sense. It represents the discovery of knowledge that addresses a problem's deep structure. The integration itself becomes a form of explanatory knowledge… understanding how separate elements must interact to produce the desired outcome.
Christensen's Conservation of Attractive Profits is fundamentally about where explanatory knowledge resides in a value chain. Profits accumulate around problems whose solutions require the deepest explanatory understanding. When a company builds integrated solutions to such problems through sustained trial and error, they aren't merely accumulating tacit knowledge… they're creating explicit explanatory theories about how to solve a class of previously intractable problems.
What appears as a "straightforward linear series of systematic decisions" to outside observers was, in reality, a Popperian process of conjecture and refutation… messy, indirect, and achieved only through what I would call a commitment to error correction. The company didn't avoid mistakes; it institutionalized learning from them, creating objective knowledge that transcends any individual contributor.
This process of knowledge creation spanning years or decades often goes unnoticed precisely because good explanations make the difficult appear simple. The solutions created through this evolutionary process contain what we can call "reach"—they solve not just the immediate problem but create a framework for solving related problems not anticipated during their development.
A company possessing explanatory knowledge to solve important problems creates durable earning power regardless of macroeconomic variables. This constitutes not just a good business, but one whose explanatory advantages grow through positive feedback loops of further knowledge creation.
Traditional value investors frequently misunderstand such companies because their methodology prioritizes extrapolation from past results over recognizing the explanatory depth of a business model. They fail to see that what appears as capital-intensive infrastructure building is actually the physical instantiation of hard-won explanatory knowledge.
When one discovers an underappreciated company building hard-to-replicate solutions with substantial reinvestment runways, one has found a business containing good explanations… explanations with reach, hard-to-vary components, and substantial problem-solving power. Such explanations constitute the true source of durable investment returns, beyond what is captured in conventional financial metrics.
The market systematically undervalues these companies because conventional analysis seeks apparent predictability rather than explanatory depth. What looks like disorder to a conventional analyst may actually be the signature of a company traversing the landscape of possible solutions more effectively than its competitors.
The fundamental error in most investment approaches is their attempt to conjure certainty where none exists. Better to embrace the inherent uncertainty while focusing on explanatory frameworks that are difficult to vary yet still account for the observed phenomena. This approach won't tell you exactly when or by how much a stock will rise, but it may reveal which companies have created the kind of knowledge that enables persistent value creation across varying conditions.
“Discovering a new explanation is inherently an act of creativity… We do so by seeking good explanations – explanations that are hard to vary in the sense that changing the details would ruin the explanation.”
Thank you for reading, see you soon!