Imagine for a moment that you move to a new country that you have never been to before.  When you get there, they give you a map of the country.  But as you use the map, you find that it does not accurately represent the country at all.  You never get to the place you want to go.

So, you complain to some of your new friends about the map, and they acknowledge the shortcomings of the map, but they say it is correct in theory, and is better than having no map at all.

This is economics and finance today, and there are changes that need to be made.  They would rather have a wrong map than admit that their theories are bogus.

Today I read Investment Management: A Science to Teach or an Art to Learn?  I think its 99 pages are well worth reading, and if half or more of the observations get implemented by the CFA Institute, the Society of Actuaries, and Departments of Business, Finance, and Economics, the entire industry will be better off.

It is better to have an accurate uncertainty, than an inaccurate certainty. We are better of professing ignorance of what we don’t know, than being certain about things where we are wrong.

Investing is an art to learn. There is little science here. Stocks and other investments do not behave like modern portfolio theory would dictate. There is not one central risk factor that accounts for most of investing. There are many risk factors, and the credit cycle.  The credit cycle is dominant, because as debts build, there is a boom in the favored asset classes.  Then, as debts become unsustainable, there are crashes where the previously favored asset class returns to reasonable pricing or less.

We have to absorb the idea that most people are not rational, they merely imitate.  “If my friends are doing it, it must be a  good idea,” is the thought of many. As such, crises are easy to understand, because people imitate “the success” of others, not realizing that an asset bought at a lower price might be good, but the same asset bought at a higher price might be bad.

We also have to grasp that physics is the wrong model for finance, and ecology offers us a better model — actors pursuing scarce resources in order to survive/thrive. In physics, it is simple.  Human actions don’t matter; what humans care about does not affect physics.  It does affect economics.

Beta vs Credit

Beta is not risk.  Risk is more akin to the likelihood of bankruptcy, and the severity thereof.  Crises happen when a lot of companies and individuals face the threat of bankruptcy.  In some ways, we need to retrain all investors to think like bond managers — examining balance sheets, cash flow statements, and avoid companies that have higher probability of bankruptcy.

What do we Need to Change?

We need to end the idea that markets natively are in equilibrium.  Indeed markets may weakly tend toward equilibrium, but the shocks to the system are far greater than the equilibrium tendency.  Markets may tend toward equilibrium, but they are almost never in equilibrium.

We must teach students that the beauty of markets is that they function in disequilibrium.  That is their glory.  We should not expect perfection of markets in the short-run, but in the long-run many imperfections get eliminated where the government is not interfering.

We need to teach that crises are normal, and not accidents.  They happen because a class of assets gets overbid, and often because of debt incurred to buy the assets.

We need to teach economic history to students, so that they grasp the wide array of what can happen in markets.  What?  That can’t happen today because the Fed watches over us?  No way.  The same problems will recur in different forms.

The most important thing to teach new students about statistics is how they can be manipulated.  Teaching them advanced statistics is overkill, because the markets are more random than that.

Quibbles

We don’t need to teach more macroeconomics to investors, because the theoretical foundations are shaky.  I agree that we need to teach more qualitative reasoning to students.  Maybe there should be some practical tests, where they work in a startup, and have to reason broadly, because there is no one to break it down to a simple level for the newcomer.

Beyond that,on page 98, if you don’t know how to value a derivative contract, you will not be able to trade it properly.  As a former mortgage bond manager, it helped me a lot to understand the math.  I could make better bids than most could.

Summary

The main idea here is to develop qualitative reasoning, and neglect quantitative reasoning when there is no reason to think it is impartial.

I write this as a mathematician who mostly understands where math fairly represents the world, and where it does not.

By David Merkel, CFA of alephblog