The ideology of modern finance

For investors looking for a good New Year's Resolution for 2011, may we suggest this one: swear off the ideology of modern finance.

Andrew Redleaf and Richard Vigilante have published their insightful view of the financial crisis of 2008-2009, which they encapsulated in an article last year entitled "It's not the size that counts: the problem isn't that banks are too big. It's that they're too opaque."

What strikes us as important for all investors to consider carefully is the connection that Mr. Redleaf and Mr. Vigilante see between the panic of 2008-2009 and what they call "the ideology of modern finance," which is built upon what they describe as "a dogmatic worship of securities markets" and the belief that "it is dangerous even to try to out-figure the all-seeing market on price or value."

Investors may be most familiar with this modern financial ideology that they are describing through the famous quotation of Burton Malkiel, a Princeton professor and one of the leading proponents of the so-called efficient market theory, who said that "a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one selected by experts."

In other words, the proponents of this modern ideology hold as their most cherished principle the belief that markets are all-knowing, and that it is useless to try to apply individual analysis to investment securities: an expert who spends all his time analyzing the choices would still do no better than a blindfolded ape.

The notable insight of Mssrs. Redleaf and Vigilante is their connection of this worship of "efficient markets" with the financial crisis. Gripped by this belief, they argue, institutional investors moved decisively away from fundamental analysis and blindly trusted their mathematical models (models based on the tenets of modern portfolio theory), ultimately with disastrous results.

As the authors explain in the article referenced above, "Under the reign of modern portfolio theory, too many Americans, especially institutional investors, have been investing almost blindly for decades." Because of this, Mr. Redleaf and Mr. Vigilante argue, "moving mortgages onto securities markets put investors with none of the expertise or information available to mortgage bankers in charge of pricing. First the mob priced them too high; then it panicked and priced them so low the banks appeared to be broke."

While this topic is crucial to the entire banking system, investors should immediately see that the central thesis has enormous implications for money management as well.

First, they should realize that the financial implosion of 2008-2009 was directly related to the rise in prominence of this new ideology of modern finance that slowly took over the professional investment world beginning in 1974 (we have written about this phenomenon previously, in previous posts such as "Beware of the Witch Doctors of Modern Finance" and "The Judgment Deficit."

Second, investors should realize that -- even though the recent crisis should have dealt a death blow to this dangerous modern ideology of finance -- modern portfolio theory and the negative investment behaviors associated with it still dominate the professional investing landscape.

This presents investors with a choice, and an opportunity.

The situation is very much like the one described in the joke we talked about in July 2009, in which two economists see a $100 bill in the street and conclude it can't possibly be real, or somebody else would have already picked it up! They believe that no great innovation could possibly be left to be made -- if anything were really worthwhile, somebody would already have done it. Investors can choose to listen to the learned professors who argue that nobody can find exceptional companies and not to bother trying, or they can instead reach down and pick up the figurative $100 bill that according to the theory should not even exist!

The real world is full of innovative individuals and companies creating new value where it did not exist before. Take a look at some of the biggest stock gainers of 2010 (or any other year) and you will find plenty of examples.

This fact presents real investors with a tremendous opportunity, to seek out innovative and well-run companies that have an opportunity to grow faster than the average company for the next several years. In this fresh new year, we recommend that investors get back to the due diligence and focus on fundamentals that the "modern ideology" teaches are irrelevant, but which actually matter more than ever.

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