From Back to the Future to Dr. Frankenstein, the mad scientist playing God with his discoveries is a familiar figure to us all. The obverse of the scientist is the artist and poetic visionary who is inspired by instinct and intellect rather than oppressive facts. And between the two cultures of art and science is “a gulf of mutual incomprehension,” to quote British scientist and novelist C. P. Snow, a gap so wide it actually poses an obstacle to the progress of mankind.
Within investment management, amidst the worst financial crisis in a generation, polarizations between feuding tribes of theorists pose a similar hindrance to solving the practical challenges we face as investors.
For some time, quantitative approaches, meaning any investment strategies based largely on math, have evolved alongside but apart from qualitative approaches such as classical fundamental analysis and behavioral finance. Inside investment firms, in separate corners of the same firm, tribes of quants and separate tribes of behavioralists investors can often be found, jockeying for influence.
This divide came into focus at the recent CFA Institute Annual Conference in Chicago. Delegates heard University of Chicago legend Eugene Fama affirm his views about efficient markets and the ultimate rationality of investors. Just the day before, Daniel Kahneman had argued for pretty much the opposite, championing his belief in the power of behavioral and psychological explanations of investment, which Fama promptly dismissed as “storytelling,” adding: “Jumps that [behavioralists] make from there to markets aren’t validated by the data. If it is irrational, it should go away.” At the very same conference, a well-regarded practitioner, GMO’s James Montier, rained scorn on models and theories, and squarely blamed them for both the last crisis and for sowing the seeds of the next one.
This polarization of opinion is also reflected in a recent CFA Institute member poll: While an overwhelming majority thought that blaming the Efficient Market Hypothesis (EMH), among other things, for the financial crisis was wrong, a minority were not so sure.
CFA Institute Member Poll: Can we blame investment theories, such as the efficient market hypothesis (EMH), for the continuing financial crisis?
Dates: 8 May 2012 – 30 May 2012. N = 245.
What are the theoretical foundations of this divide? Of course it’s dangerous to divide anything into two. But rather like the divide between the arts and the sciences, theoretical finance has forked down two highways: behavioral finance and modern portfolio theory (MPT). In fact MPT refers to several waves of theories. The first from 1952 established the capital asset pricing model (CAPM), which explains mathematically why diversification reduces risk in a portfolio of stocks. The approach is effective at providing a level of risk corresponding to investor expectation, as well as a willingness and ability to take on risk, even though the methodology is criticized for defining risk simply as portfolio volatility.
Since the early 1970s, a second wave of theories — including the random walk hypothesis, the efficient markets hypothesis (EMH), and the arbitrage pricing theory — reinforced MPT. But these three theories all suffered from academic insistence on the impossibility of beating the market, which a few investors regularly did. The paradigm has also been attacked on the basis of statistical anomalies, the existence of bubbles, long-run trends and mean reversion, and the problem of nonlinear events, not least the recent banking crisis.
Also, since the early 1970s, passive investing, or investing to match indices, caught on with investors, a fact generally supported by the theorists as the best way for investors to access the market portfolio. For more active investors, among the interesting and useful things that remain unexplained by (but identifiable precisely because of) these various models, are the continued outperformance of smaller companies, value stocks, and momentum stocks.
So why didn’t behavioral finance supplant EMH? Despite early promise, behavioral finance, or BF, which seeks cognitive or behavioral explanations for economic decisions, appears to have run into a theoretical cul-de-sac of its own creation. Of course there are well documented departures from EMH in the form of behavioral biases. For example, individuals, with hindsight, tend to be risk averse in the face of gains and risk seeking in the face of losses. While EMH proponents argue that these inefficiencies will eventually be arbitraged away, few practitioners in the BF camp have found ways of actually exploiting them. Other more recent theories, the adaptive markets hypothesis and Yale economist Robert Shiller’s theory of market volatility and noise trading, while each adding smart insights to our understanding of markets, have so far failed to catch on with practitioners.
The “practitioner-usefulness test” is a critical test, but not the end of the story. The plain truth is that few professional investors — whether quant or not — blindly believe that EMH or CAPM holds. They simply use knowledge of these models and their weaknesses as a part of their best endeavors to reach an understanding of markets for the benefit of their clients. For example, a large part of the “active quantitative” school of thought only exists because these proponents believe that through mathematical modeling they can identify and exploit inefficiencies, so many of them by definition don’t think EMH holds.
Financial models attempt to incorporate crucial elements to add discipline, evidence, and measurement into the investment decision-making process. An active quantitative manager’s endeavor is essentially a mathematical one, of identifying critical elements and turning them into a deliberately simplified (and likely imperfect) description or equation in order to provide useful insights to aid understanding.
Recent events exposed many failures to correctly interpret model outputs and properly specify relevant model inputs, such as extreme events. The lesson learned is that better models reflecting future uncertainty likely need more sophisticated and flexible mathematics, not less.
Financial professionals use countless methodologies to manage assets, so the art or science — whichever you prefer — is inherently complex. Simultaneously, investment judgment will always involve unpredictable and irrational human behavior, so mathematics and science can never take over completely.
This post is an extended version of Mark Harrison’s recent Financial Times article entitled “Unifying Theories Fail to Bridge Divide.”
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
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