Is Mainstream Finance Theory Adrift?
US President Harry Truman once joked that he wanted to find a one-armed economist who wouldn’t be able to hedge every opinion by saying “On the other hand. . . .” In the years following the 2007–09 financial crisis, countless policymakers and investors could well understand Truman’s frustration with equivocating experts. Definitive answers were rare. Fundamental precepts — from macroeconomics to monetary policy to Modern Portfolio Theory — were shaken or even shattered. At times, the loss of conviction and consensus appears to have culminated not in a revolution of understanding but rather in the destruction of any pretense of understanding.
By way of an example, one need look no further than the concept of a “bubble.” To most observers and market participants, the loud popping sound produced by Lehman’s collapse in 2008 and the gummy substance covering the face of the global financial system would seem to be sufficient evidence of a burst bubble. According to mainstream finance theory, however, bubbles are by definition impossible. The very idea of a bubble is nonsensical. In 2010, Eugene Fama, one of the primary architects of the efficient markets hypothesis (EMH), went so far as to say, “I don’t even know what a bubble means.”
This state of affairs makes the global financial crisis different from any other crisis since the end of the Second World War. “One of the most interesting aspects of this particular crash is that finance theory, not simply the practices of the financial services industry, has been directly blamed for the crisis,” write the authors of a new CFA Institute Research Foundation monograph entitled Investment Management: A Science to Teach or an Art to Learn? As the title suggests, the authors —Frank J. Fabozzi, CFA; Sergio M. Focardi, and Caroline Jonas — set for themselves the task of figuring out where investment management is in the wake of the crisis. If they had undertaken the project as a kind of literature review or meta-study, the result might have been a helpful compendium of the latest thinking. Instead, they solicited input from a globally diverse group of “opinion contributors,” including notable academics, investment practitioners, and human resources managers at asset management firms. The result is an engaging and remarkably concise reassessment of investment theory and practice.
The analysis begins by examining the theoretical underpinnings of efficient markets, rational expectations, optimization, and general equilibrium theory. A decisive conclusion comes quickly: “The fact that the theory makes impossible demands on our knowledge is a crucial point that affects all mainstream general equilibrium theories,” the authors write. “Fundamental theoretical variables, such as prices, are defined as the discounted present value of an infinite stream of future quantities that are not observable.” From there, the discussion quickly turns to “finance theory as physics envy.”
Whatever finance theory may be, it is not analogous to the physical sciences. “Economics is not about studying the laws of nature; it is about studying the behavior of an ever-changing human artifact,” as the authors put it. Could it be a social science? It seems to have elements of a social science but arguably belongs in a different category for reasons that are well explained in the monograph.
Although this discussion is interesting in its own terms, the heart of the publication lies in a section dealing with how the practice of investment management needs to change following the crisis. Here, the perspectives of the “opinion contributors” working in asset management help to shift the discussion away from purely theoretical arguments and put the focus on key practical considerations for asset managers. The authors’ take on the state of risk measurement, risk management, and systemic risk models probably will be of particular interest to current practitioners.
The final chapters consider the education of future investment professionals. Again, although the topic might sound like an academic exercise, observations from human resources managers, which are woven into the discussion, have compelling implications for people in early or mid-career. The chapter “How Will Future Professionals Land a Job in Investment Management?” might accurately be re-titled “How Will Current Professionals Further Their Careers in Investment Management?”
The question of “art” versus “science” deserves further mention. In considering whether finance theory can be viewed as a “science,” the authors touch on the history of science in the early modern period. Inevitably, Galileo comes up because he famously asserted that the language of nature is mathematics. Where finance and economics are concerned, the monograph authors make the important observation that “forcing mathematization can actually impoverish, not enrich, knowledge.” Many of the practitioners quoted in the book also express the concern that finance has become too “mathematized.” Those who have read Peter Bernstein’s Against the Gods: The Remarkable Story of Risk may be reminded of his warning that numbers can become fetishes. But as the authors point out, “to deny that some parts of economic theories can be mathematically described . . . would be unscientific.”
In some ways, the example of Galileo can be instructive for the current state of investment management. The legendary scientist is widely perceived as being vindicated by history, but it’s worth keeping in mind that Galileo was actually wrong on critical points of science. For example, he insisted on an elaborate but incorrect explanation of the tides and ridiculed Johannes Kepler’s hypothesis that the tides were influenced by the moon. Galileo believed that he had proved the theory that the earth orbits the sun, but that claim could not be proved empirically until much later. As the monograph authors correctly note, “with the mathematics known to Galileo, one could not have formulated modern physics.”
Galileo’s most significant contribution to science was not in discovering new facts but in pioneering the way for future discoveries. He was a great proponent of applied mathematics and what has come to be called the scientific method. There are striking parallels between the rise of science in the early modern period and the development of an intellectual framework for thinking critically about finance. As a formal discipline or body of knowledge, modern investment theory is less than a century old. More than a century after the death of Galileo, it was possible to calculate the orbits of planets yet impossible to plot the longitude of a ship at sea. Many a lost or shipwrecked sailor in the 18th century might have expressed a colorful opinion about the practical utility of scientific theories.
The lack of a complete scientific model of navigation didn’t prevent a robust maritime industry from evolving. Equipped with tools no more advanced than an astrolabe, a sextant, or a compass, seafaring people were able to navigate well enough to enable the development of trans-oceanic civilizations. Busy trade routes and commercial networks extended around the globe. And all this activity was based on artisanal technology — the work of smithies, carpenters, shipwrights, and many more — that was literally more art than science. With this historical model in mind, consider the monograph authors’ definition of economics and finance as studying the behavior of an ever-changing artifact.
If the deficiencies of rational frameworks and equilibrium models leave us feeling lost on a vast ocean of financial uncertainty, it doesn’t mean that no further progress is possible. Future investors may be able to look back on our age as a difficult middle passage in the voyage to discover a working science of finance. In the meantime, as the authors of this Research Foundation monograph make abundantly clear, asset management firms have a renewed interest in hiring people who can apply critical reasoning, intuitive judgment, and qualitative “big picture” analysis in the investment decision-making process.
Perhaps we can think of this skill set as the investing equivalent of what sailors historically called “dead reckoning.”
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