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.
“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…
The finance field over the past few decades has become increasingly esoteric and academic, not reflecting the real world. When in classes learning about "efficient markets" and "rational investors" I was always reminded of the old joke of a theoretical physicist's advice to a farmer that ends with "let's assume a spherical cow in a vacuum…"
The problem has been that most of the other finance students DIDN'T see the similarity (or at least weren't encouraged to see the similarity), and went into the workforce assuming efficient markets and rational investors in their business decisions. While they serve as good simplifications for understanding market activities most of the time, they need to be balanced with an understanding of psychology and behavioral finance.
The biggest problem with real-world finance is not recognizing the difference between risk and uncertainty. Risk is related to probabilities – if I have a box with 10 balls, half red and half white, I have a 50% risk of choosing a red one. Uncertainty is not knowing what the distribution is or even what's in the box (there might be a black swan in there with all those balls).
In finance, we make educated estimates of uncertainty and call it "risk," then work with theories that deal with the proper definition of risk.
Posted on August 2, 2009 at 6:58 pm.
You really hit the nail on the head with
"While they serve as good simplifications for understanding market activities most of the time, they need to be balanced with an understanding of psychology and behavioral finance." which reminds me of the Einstein quote "Make everything as simple as possible, but no simpler"
So would it be fair to say, given I haven't taken an econ course in over 20 years, that the issue is that "beta" isn't being measured correctly? Or that it doesn't take into account "uncertainty"?
Posted on August 3, 2009 at 4:13 pm.
I would say the problem is an over-reliance on beta in particular, and financial models in general. Beta describes how closely a stock or portfolio follows the general market. But beta isn't fixed, so you can't really measure it correctly (or more accurately, your measurements are correct at a specific time, but that doesn't mean it will stay the same in the future). It requires a deeper understanding of what DRIVES beta, which is psychology.
During the last financial crisis, the beta of almost everything approached 1. It didn't matter where your money was, it was going down. When your investment and your hedge for your investment approach a correlation of one, instead of hedging you just doubled your losses.
The problem with finance is an over-reliance on reductionist mathematical models. We're starting to see a larger realization of this, and more people are now following behavioral finance. But all of what I've read in behavioral finance is less a new theory and more a disproving of an existing theory (efficient markets hypothesis). It doesn't provide any new theories or testable hypotheses, it just says "EMH is wrong in these instances…"
Posted on August 5, 2009 at 11:10 am.
Thankyou very much, I’ve found this extremely useful!
Posted on April 13, 2010 at 3:18 pm.