Valuation-Informed Indexing #145

by Rob Bennett

The Buy-and-Holders did something wonderful. They rooted their investment advice in the academic research. This provided both accountability and independence. You can’t complain that Wall Street Con Men are trying to pull a fast one on you when the people from whom you obtain your advice on how to invest are rooting what they say in the research advanced by those holding doctorates in economics. Doctorates in economics are not on the take.

Doctorates in economics DO make mistakes, however. Therein lies the rub.

When some Wall Street fellow says something that sounds fishy, you don’t place much confidence in it. You figure that it is part of a sales pitch. When a fellow with a doctorate in economics says something that doesn’t seem to add up, you assume that the problem is on your end. Probably you are just not smart enough to get it. We are all inclined to put more of our trust in academics than in people with something to sell.

The great idea will produce great results somewhere down the road. When the academics in this field get their act together, their input really will be more valuable than the input provided by salesmen. Unfortunately, in the early days of the great experiment, the practical result of putting the academics in charge of what investing advice is promoted most heavily has been to give more power to long discredited but not yet corrected academic ideas.

All stock investors should read an amazing paper produced by the University of Copenhagen Economics Department. It is titled The Financial Crisis and the Systematic Failure of Academic Economics. This is the real story, the news that unfortunately does not often enough end up in the newspaper.

I’ll set forth a few snippets that you can use to determine whether reading the full paper is worth your time:

A Summing-Up: “The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s focus on models that, by design, disregard key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.”

Economists Who Can’t Explain Economic Crises Aren’t Doing the Job: “The current academic agenda has largely crowded out research on the inherent causes of financial crises…. In fact, if one browses through the academic macroeconomics and finance literature, ‘systemic crisis’ appears like an otherworldly event that is absent from academic models. Most models, by design, offer no immediate handle on how to think about or deal with this recurring phenomenon. In our hour of greatest need, societies around the world are left to grope in the dark without a theory.”

How Things Got on the Wrong Track: “Many of the financial economists who developed the theoretical models upon which the modern financial structure is built were well aware of the strong and highly unrealistic restrictions imposed on their models to assure stability. Yet, financial economists gave little warning to the public about the fragility of their model even as they saw individuals and businesses build a financial system based on their work.”

Ethical Responsibilities Have Been Ignored: “Financial engineers are extremely bright, and it is almost inconceivable that such bright individuals did not understand the limitations of their models. A second, more likely explanation, is that they did not consider it their job to warn the public. If that is the cause of their failure, we believe that it involves a misunderstanding of the role of the economist, and involves an ethical breakdown. In our view, economists, as with all scientists, have an ethical responsibility to communicate the limitations of their models and the potential misuses of their research. Currently, there is no ethical code for professional economic scientists. There should be one.” [italics in original]

The Rational Expectations Model Is Not Supported by Empirical Research: [The Rational Expectations Model] is not at all an approach based on, and confirmed by, empirical research. In fact, it stands in stark contrast to a broad set of regularities in human behavior discovered both in psychology and what is called behavioral and experimental economics. The corner stones of many models in finance and macroeconomics are rather maintained despite all the contradictory evidence discovered in empirical research. Much of this literature shows that human subjects act in a way that bears no resemblance to the rational expectations paradigm.”

Uh-oh.

Brave people wrote the brave words of this very important paper. You should spend some time with it.

Rob Bennett has recorded a podcast titled “Why Stocks Let You Down and How to Make Sure It Never Happens Again.” His bio is here.