Investment Management: A Science To Teach Or An Art To Learn?

Investment Management: A Science To Teach Or An Art To Learn?

Investment Management: A Science To Teach Or An Art To Learn? by Frank J. Fabozzi

H/T David Merkel/Alephblog

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Investment Management: Description

Following the 2007–09 financial crisis, mainstream finance theory was criticized for failing to forecast the market crash, which resulted in large losses for investors. Has our finance theory, which many consider an idealization that does not take reality into account, failed investors? Do we need to reconsider the theory and how it is taught (and practiced)? Investment Management: A Science To Teach Or An Art To Learn? explores current critiques of mainstream theory and discusses implications for the curricula of finance programs as well as for practitioners. In so doing, the authors integrate a review of the literature supported by conversations with finance professors, asset managers, and other market players.

Investment Management: Excerpt from e-book

Because Frank Fabozzi, Sergio Focardi, and Caroline Jonas have, in Investment Management: A Science To Teach Or An Art To Learn?, looked at the question of how to teach finance from the viewpoint of instructors, I will briefly consider the perspective of a student. What do I need to know? What are the timeless truths I need to understand even if there is no immediate application for them? What are the controversial propositions, and how close are we to resolving them? What is simply wrong?

The basics of investment finance can be distilled down to about eight ideas:

  • time value of money,
  • discounted cash flow (as the fair value of an asset),
  • bond math and duration,
  • the no-arbitrage condition,
  • market efficiency,
  • portfolio efficiency and optimization,
  • the capital asset pricing model (CAPM) and market model (alpha and beta), and
  • option pricing and optionality.

To these basics, I would add the Modigliani and Miller indifference principles for capital structure and for dividend policy; although these principles are usually taught in corporate finance rather than investment courses, they are very important for making investment decisions. That’s it. I’m done. That’s the finance course that I’d like to take—I think.

The first few ideas listed are relatively uncontroversial. But when I, as a student, get to the middle of the list, I’m tempted to howl, “Wait a minute!” Market efficiency? The market, says the great investor Jeremy Grantham, is “deliciously inefficient.” His vast fortune is testimony to the fact that somebody can beat the market. Graham and Dodd and Warren Buffett and practically every hedge fund manager would agree.

So, should finance professors teach market efficiency as a timeless truth, a controversial proposition, or an idea that has been tested and found to be wrong? I would say they should teach it as a vitally important null hypothesis and point of departure for evaluating the claims of those who say they can beat the market.

Portfolio efficiency says that investors should try to build portfolios that maximize utility, which consists of expected return minus some measure of risk. But where are investors supposed to get their return expectations from? What is risk? Is it volatility? Downside risk? Permanent loss of capital? When I go to work in an investment management firm, will I really be building portfolios that maximize return subject to a penalty for risk, or will I be doing something else to deliver the desired results to customers?

The CAPM is another problem area. The CAPM is a magnificent piece of reasoning, but the linear relationship that it posits between beta risk and expected return does not hold exactly. Active management is basically a search for assets with high returns and low risk, which the CAPM says cannot exist. The debate about the CAPM is closely related to the debate about market efficiency. Should professors present the CAPM as a hypothesis, as a well-reasoned framework for thinking about the relation between risk and return, or as truth?

See full e-book on “Investment Management: A Science To Teach Or An Art To Learn?” in PDF Format via CFA institute.

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