Finance theory creates a distorted image of the investment world
The things we name risk free are now some of the riskiest, warns New Sparta’s Jerome Booth
From time to time, political leaders have faced a choice between breaking up large business conglomerates when they become too powerful, or getting cosy with them.
US presidents Andrew Jackson and Theodore Roosevelt chose the former, enabling the US to stay competitive and productive. After 2008, our leaders chose the latter, often taking bankers’ advice, with senior personnel switches between private and public sectors. The cosiness with ever-larger banks has, in part, been fed by the ideas that banks can self-regulate, and an idea from finance theory that markets are naturally efficient.
Finance theory’s practical limitations are serious and well-documented, but that has not stopped its widespread application. Simplistic assumptions have led to massive errors and crises again and again. When “impossible” events occur and models crash, investors simply reboot their computers and start again.
Finance theory has contributed to huge distortions in the way savings are invested. Pension funds have grown to dominate stock and bond markets over the past few decades. There have been many benefits, but a big cost has been herd behaviour in asset allocation due to asymmetric incentives.
Winning or losing conventionally leads to little personal cost or benefit to the average pension fund asset allocator. Unconventional success may lead to a pat on the back, yet to lose unconventionally can be career limiting. The result is herding, including the use of theory known to be deficient, because one’s peers also use it.
Up to a certain age toddlers don’t believe things exist if they cannot see them. Some of us are a bit like that in finance: if we cannot measure it, we ignore it.
Risk is multi-faceted and complicated, different for different people because we have different liabilities, information, reaction speeds and behavioural and institutional constraints. Most people care more about large permanent loss than volatility, yet risk has become synonymous with easy to measure past asset price volatility.
In the late 1950s, Harry Markowitz, the US economist, said an asset’s volatility (“risk”) can be explained by three things: idiosyncratic movement not correlated to any other stock, which can be diversified away; co-variances with other stocks — a measure of the degree to which returns on two risky assets move in tandem; and correlation to an index.
For computational ease he simply ignored the co-variances with other stocks. Ever since it has wrongly been assumed it is impossible to perform better than an index with lower volatility, indices have been used to define asset classes and these asset classes have been used as the building blocks of asset allocation.
Furthermore, the definition of what is and what is not an asset class is arbitrary, a function of sustained marketing more than anything else.
The resulting distorted set of asset classes does develop, but unfortunately changes in the real world are probably occurring faster. The most obvious two cases of distortion are the woefully inadequate allocations to emerging markets, which now comprise the bulk of economic activity on the planet, and to illiquid assets.
To add to this distorted image of the world, we are now in a period of significant global structural imbalances, high indebtedness in the developed world and international monetary imbalance in particular. Macroeconomic understanding of these structural problems should be driving overall asset allocation, but it is not because finance theory has nothing to say about macroeconomics.
There is no mean reversion (the theory suggesting prices and returns eventually move back towards the average) in markets with structural change, but asset allocator models assume mean reversion anyway, regardless of macroeconomics, politics or historical knowledge. Such knowledge is not as easy to evaluate as it is to put a few numbers in a model and read the output.
Looking back and extrapolating is what finance theory helps us do. This has its place, but can preclude the ability to see the largest, most dangerous, structural shifts.
Finance theory seemed to work well enough in stable macroeconomic environments, but is now misleading asset allocators into false complacency.
The things we name risk free — an abuse of the English language — are now some of the riskiest. Investing in assets perceived as risky may constitute the best hedge available for the worst scenarios.