Beware of the witch doctors of modern finance

In 1974, towards the end of the biggest and most sustained bear market since the Great Depression up to that point (see this chart for historical perspective), something very significant happened in the world of portfolio management.

Theories that had been developing for two decades in academia were widely adopted by many investment management professionals who had previously ignored them or dismissed them as a bunch of "baloney." Specifically, academic work by economists such as Harry Markowitz, William Sharpe and Eugene Fama tried to quantify the concept of risk and mathematically incorporate it into the construction of portfolios.

That same year, investment manager Peter L. Bernstein founded The Journal of Portfolio Management to explore, discuss, and disseminate these new ideas. Bernstein later said, "The market disaster of 1974 convinced me that there had to be a better way to manage investment portfolios. Even if I could have convinced myself to turn my back on the theoretical structure that the academics were erecting, there was too much of it coming from major universities for me to accept the view of my colleagues that it was 'a lot of baloney'" (quoted in Hagstrom, The Warren Buffett Portfolio, page 28).

In the very first issue of that new periodical, Nobel laureate Paul A. Samuelson wrote an article entitled "Challenge to Judgment" which opened with a depiction of this new tectonic shift in money management:

"Once upon a time, there was one world of investment -- the world of practical operators in the stock and bond markets. Now there are two worlds -- the same old practical world, and the new world of the academics with their mathematical stochastic processes."

Between that 1974 bear market and the current bear market, the second of the two worlds identified by Samuelson grew at an exponential pace, while money managers of the old school became harder and harder to find.

We have made it as clear as we possibly can, in several places on this blog going back to our very first post, that we believe in the classic, pre-1974 approach to money management, which we characterize as being based on both practical experience and a disciplined fundamental analysis of the companies that issue market securities like stocks and bonds. Our portfolio management process is directly descended from that used by Richard Taylor and Thomas Rowe Price when they managed money together in the 1960s, before the great shift of 1974.

We have also made clear our view that there are serious drawbacks to what Samuelson calls "the new world of the academics with their mathematical stochastic processes" (in particular, we outlined several in this previous post). We would disagree with Peter L. Bernstein that what was coming out of major universities couldn't be "a lot of baloney." To the contrary we think it was!

We also believe that 2008 may well be a year that causes reconsideration of the investment world's rush to embrace "academic mathematical stochastic processes," or at least it should. If you are a client of the mainstream financial services industry, you are probably very familiar with the current products of this post-1974 approach: quant strategies, "black box" strategies, "130/30 funds," "negatively correlated assets" that turned out not to be negatively correlated at all, "portable alpha," asset beta, risk-free assets, and the litany could go on and on.

We say that the current year should cause the investment world to ask if some of the products of that "new world" might actually be "a lot of baloney" after all, but at least one famous market observer thinks that is probably too much to hope for.

Nassim Nicholas Taleb's bestselling 2007 book The Black Swan: The Impact of the Highly Improbable introduced a graphic new term to describe what he calls "large-impact events with small but statistically incomputable probabilities." A black swan is an event that blows up the models because it is unanticipated. Before the discovery of a black swan in Australia in the 1600s, nobody in Europe would have been able to tell you the probability that a black swan existed, because in Europe they do not, and in fact the assertion that "all swans are white" was used as a truism in texts teaching logic.

In a notable interview from earlier this year, Professor Taleb answered a question about why Wall Street does not seem to learn from past catastrophes, saying:

"Let me blame business schools and the financial economics establishment - they have a vested interest in promoting models and devaluing common sense. I worked on Wall Street for close to two decades in trading and risk management of derivatives. I noticed that while portfolio models got worse and worse in tracking reality, their use kept increasing as if nothing was happening. Why? Because in the past 15 years business schools accelerated their teaching of portfolio theory as a replacement for our experiences. It looks like science, and they have been brainwashing more than 100,000 students a year."

He also added, "The problem may also be the Nobel in economics that gave a stamp to these junky theories. Someone needs to make the Nobel committee account for this, for the damage to society - and I hope to do so."

We heartily agree. It has been our observation that the current monolithic financial services industry is built upon a false pretence of having access to some secret knowledge about what is going to happen next with interest rates, or the price of oil, or the performance of one market sector versus another sector.

As we wrote in "Stock Market Guessing," "it is a rare member of the advisory profession who will admit that it is impossible for them to know any more than you do about what is going to happen next." The financial services industry in general, and their sister industry the financial media, have become a kind of class of witch doctors, claiming access to knowledge of the next moves of the market that the ordinary individual cannot possess. In the case of quantitative strategies, the computer models or "black boxes" become the witch doctors, able to predict something that mere mortals cannot.

Our message continues to be that there is no magic to this, and that investors would do well to stop relying on the witch doctors of the financial world. We advocate that investors apply common sense and rigorous analysis to finding "well-run companies in front of fertile fields of growth," as we have explained several times before (such as in this post).

We believe investors should look for fertile fields of growth in areas where paradigms are changing, as we have also explained previously. No mathematical model or algorithm can tell you what previously unknown company is going to innovate next. It is quite possible for ordinary investors to identify good investments, given the time and the inclination to do so, and the discipline to persevere through gut-wrenching twists and turns.

The current bear market enables investors to realize the power that a crisis can have in changing the direction of an entire industry, and better appreciate how the 1973-1974 bear market gave an opening to what Paul Samuelson (who supported the new theories) called "the new world of the academics with their mathematical stochastic processes." In this bear market much of that academic mumbo-jumbo has turned out to be quite harmful (several hedge funds based on quantitative models blew up, and supposedly non-correlated assets such as international funds and commodities trackers caused investors to have bigger losses in their portfolios instead of smaller losses).

But there is an alternative, that most of the financial services industry turned its back on in 1974, that we believe is just as valid today as it was when the world rushed into the "new world of the academics."

For future posts dealing with this same topic, see also: