Foundation Blocks of Modern Finance vs 2009

Ran into this 2004 economics paper referenced by Wayne Marr on twitter. Several quotes that jumped out at me for a variety of reasons. All economics links added by me.Capital_Market_Line

“The foundation blocks of standard finance were now in place, supporting one another.  Investors are rational, prices are efficient, risk is measured by beta and investors form portfolios by the rules of mean-variance portfolio theory.” (1968) (pg 6)

and

“…a 1929 article in The Literary Digest stated: “The first step in a safe and sane financial program is insurance…After insurance, the next requirement is to build up a cash reserve of at least $1,000 in the savings bank.  After that, automatic thrift should be contracted for through installment savings plans, such as building-and-loan associations offer.  When these fundamental steps have been taken, the investor is in position to acquire high-grade bonds and guaranteed first mortgages on real-estate.  The next advance can be toward diversified preferred stocks, which offer a somewhat higher return….The last step should be outright purchase of the best grade of diversified common stock.”  (p. 55).” (pg 11)

Is it just me or does that advice from 1929 advice sound a lot like the cult of, sage advice giver, Dave Ramsey? Hmmm. The article concludes

Facts I did not know then but know now show that speculators stabilize prices at some times but destabilize them at others.  I have changed my mind as facts changed.

Much of finance has changed since the Financial Analysts Journal was founded in 1945, but the drive to uncover facts and make sense of them remains. Change of mind is an integral part of the process. As Maynard Keynes famously said “When the facts change, I change my mind.  What do you do, sir?”

– Statman,  Klimek, 2004

Some of these economics debates will never be settled. If investors are rational or normal for example. If speculators stabilize or destabilize markets.

I’d expect some economics debates will be settled sooner such as if high speed computers give an unfair advantage. Or if commercial real estate is in a bubble. What I do know is we aren’t out of the woods yet in 2009. But I have a sneaking optimism which is somewhat unlike me when it comes to our financial systems…