Financial History: What Are the Lessons for Investment Practitioners?
What are the key lessons from financial history, and how do investment professionals go about applying these lessons to investment decision making? This was the theme of a panel discussion organized by CFA Institute together with Cass Business School in London this June.
Some of the key lessons that emerged from the discussion are:
- Each new financial crisis that is portrayed as different is often not that different from the past crises.
- Reading history makes us aware of situations that are possible today but seem unimaginable because we have not witnessed them in our lifetimes.
- Politics can and does trump economics.
- While it is desirable, it is far from easy to learn from financial history.
Russell Napier, a consultant at CLSA and author of Anatomy of a Bear: Lessons from Wall Street’s Four Great Bottoms, served as the moderator for the event. He opened the discussion with a quote from James Grant, founder of Grant’s Interest Rate Observer:
“Progress is cumulative in science and engineering, but cyclical in finance.”
Napier said that unlike professionals in the physical sciences, financial services professionals often repeat the same dangerous experiments and mistakes of the past. The underlying reason, he argued, is that finance and economics are not hard sciences; they are about people and involve human behavior in the face of greed and fear.
He believes that financial history is often missing from the economic discourse because of the influence of the efficient market hypothesis: If all available information, which is history, is fully reflected in current asset prices, then the study of history has to be irrelevant for the future. Finance has been distilled down to a set of equations, according to Napier, but value cannot be captured by mathematics alone. He noted that while the financial crisis has weakened the hold of the efficient market hypothesis, the challenge is how to learn from financial history and apply it in practice.
Robert Jenkins, adjunct professor, London Business School, and a member of the board of governors of CFA Institute, said that financial history is a source of lessons that can save great expense in the future. He noted that when he joined an asset management company in 2007, he found to his surprise that the average age of a fund manager was only 35. Jenkins said that if you were born in 1973, “You were in the cradle at the time the dollar devalued, and it had devalued at that point for the second time. You were in nappies when New York City nearly went bankrupt. You were a youngster when the petrol lines were forming outside these doors. You were barely 10 years old when 30-year U.S. Treasury yielded 14%, Eurodollar deposits 18%, and U.S. and U.K. inflation were galloping towards 20% per annum.”
Jenkins cautioned that it is being unwisely assumed by market participants that they will continue to easily get in and out of assets due to relatively recent freedom of capital flows. He stated that historically, state intervention has been the norm rather than the exception, and faced with economic instability, today’s governments will also intervene in the markets. “Short-selling bans in Europe, bond purchase penalties in Brazil, exchange controls in Cyprus are but a foretaste of the future,” Jenkins said.
Watch the entire panel on financial history above.
Geoffrey Wood, referring to the book This Time Is Different, by Carmen Reinhart and Kenneth Rogoff, said that one of the most important lessons from history is that this time is not different. Wood, professor emeritus of economics at the Cass Business School, cautioned that it is very important to study history mindful of what information was available to the people at that time. He sees no exact parallels in history, but useful ones can be drawn.
He reminded the audience that the gold standard in the past provided much better price stability than in the more recent noninflationary, constant-growth period starting mid-1980s, often referred to as the Great Moderation. Wood said that Gordon Brown’s assertion that boom and bust would be ended through economic policy, thus putting an end to the business cycle, was misguided. Wood argued that the business cycle has many causes and cannot be ended through public policy.
Wood believes that every great development in financial history is associated with a fiscal crisis, with debt and spending growing at an unsustainable rate. He said that when Robert Lucas, a Noble Prize–winning economist, was asked which one book would he would take with him should he be appointed as a policy adviser in Washington, DC, Lucas chose A Monetary History of the United States by Milton Friedman and Anna Jacobson Schwartz. He added that the core lesson in this book is that governments’ making policy as an instant reaction to events is dangerous and that good policy is set by rules. Wood remarked that this core lesson was well put by Ronald Reagan when he famously said: “The nine most terrifying words in the English language are: ‘I’m from the government, and I’m here to help.'”
Saker Nusseibeh, CEO and head of investments, Hermes Fund Management, and chairman of the 300 Club, believes that many things that seem new and exciting have been tried before. He said that futures contracts are not new, claiming that they are discussed in the Old Testament, and the oldest extant futures market is the vegetable futures contract market in downtown Cairo, which has been operating for a thousand years. Nusseibeh added that the idea of BRIC growth economies is also not new, and accounts of investors from late 1800s show that these same four countries were their main investments in both equity and debt. He argued that while financial history is long, financial data are very limited; most practitioners in the market use data that are at best 15 years old, whereas the answers to many questions require much more past data than that.
Nusseibeh cautioned that finance is unlike natural science: It involves human interaction. He emphasized that what governs societies is not economics but politics, and historically, it is political rather than economic developments that have stronger correlation with market returns. Nusseibeh argued that with elections held every five years in democracies, politics is geared towards reelection, and it is even more short term in nature than finance is. His advice to the audience was to study history and politics and how politics will affect investment.
Nusseibeh was critical of contemporary financial modeling practices:
“Distrust models, distrust models enormously, and once you are done with distrusting models, distrust them again because they give you a false sense of security.”
For those wanting to learn financial history and fund management, the panel recommended the following books (which are listed below in no particular order):
- A Monetary History of the United States, 1867–1960 by Milton Friedman and Anna Jacobson Schwartz
- Essays: Moral, Political and Literary by David Hume
- Where Are the Customers’ Yachts? Or a Good Hard Look at Wall Street by Fred Schwed, Jr.
- An Engine, Not a Camera: How Financial Models Shape Markets by Donald Mackenzie
- This Time Is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff
- Triumph of the Optimists: 101 Years of Global Investment Returns by Elroy Dimson, Paul Marsh, and Mike Staunton
The event was organized as part of the Future of Finance project by CFA Institute, a long-term global effort to shape a trustworthy, forward-thinking financial industry that better serves society.
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.
Photo credit: New York World-Telegram and the Sun Newspaper Photograph Collection (Library of Congress).