Kick the Dogma - The Book: A Preface

“…the discipline of economics has yet to get over its childish passion for mathematics, and for purely theoretical and often highly ideological speculation at the expense of historical research and collaboration with other social sciences. The obsession with mathematics is an easy way of acquiring the appearance of scientificity without having to answer the more complex questions posed by the world we live in.” – Thomas Piketty, 2014

This book is about investing, the process and the profession. The latter has been much maligned through the decades of my involvement, much of it deserved. The profession is often its own worst enemy, with obsessions over silos, style boxes, and what is happening in the market today. It is slave to a process created in the laboratory-like setting of academia, in this case the school of economics generally, and rational choice theory specifically. It is the primary goal of this book to break those chains, provide new explanations for the industry’s shortcomings, and leave something hopeful in its wake.

            Understanding why and how we got here is critical to breaking with the past and moving forward. For five decades, academia’s unholy trinity (Modern Portfolio Theory, the Capital Asset Pricing Model, and Efficient Market Hypothesis) has held sway over the investment management profession, from business schools to Wall Street. The business of finance has always attracted the interest of PhD economists, brilliant mathematicians all, trying to reduce the complexity of markets to an array of formulas. If all you have is a hammer, wrote Abraham Maslow, everything looks like a nail.

The net result is a triumvirate of mathematical frameworks I collectively refer to as “Modern Finance” for convenience. With the goals of portfolio construction and asset allocation in mind, each subsequent model builds on the assumptions of the prior, attempting to grab more intellectual real estate with each evolutionary turn. All roads lead to a grand Theory which concludes that security prices are always right, those prices cannot be forecast, and any attempts to do so are destined to fail.

There’s great comfort in being able to “solve for x.”  For the most mathematically inclined economists there has been a propensity to approach their profession as if it can produce the specificity found in one of the natural sciences. Unfortunately, we now know a social sciences approach would have been more appropriate. As physicist Nick Herbert wrote, “Although mathematics originates in the human mind, its remarkable effectiveness in explaining the world does not extend to the mind itself. Psychology has proved unusually resistant to the mathematization that works so well in physics.” (Quantum Reality: Beyond the New Physics).

            The psychology of economic decision making is made invisible by Modern Finance through a simplifying assumption, that humans are unfailingly rational, all evidence to the contrary. But to investors indoctrinated in the Theory, behavioral science is more than a test of faith; it’s the missing link. Human foibles can explain nearly everything in the investment industry, from the failure of active managers to the success of factor investing. Modern Finance disciples, the Believers, beg to differ. Through a combination of research and anecdotes, this is the first conflict the book aims to resolve in favor of the Skeptics. *

 (to be continued…)

* The late Robert Haugen already used “Zealots” and “Heretics,” which are much better than “Believers” and “Skeptics.” But you get the idea.

Risk and Return Revisited

Risk and Return Revisited

Harry Markowitz, Nobel prize winner and creator of Modern Portfolio Theory, passed away on June 22.  His work, dating back to the 1950’s, led to the Capital Asset Pricing Model, Efficient Market Hypothesis, and the $11 trillion world of passive investing known as index funds. He gave structure to portfolio management where none existed before, shifting risk management from the security level to the portfolio level. Since the early 70’s, business school students have been indoctrinated in the modern finance canon he inspired, including Modern Portfolio Theory’s original sin: defining risk as short-term price volatility.

Fast forward 50 years. A quarrel unfolds on social media between a quantitative equity fund manager and a private equity investor. The private equity investor, Mr. P, marketed his fund’s low volatility, and therefore superior “risk-adjusted” returns, to the investment community. The prices Mr. P used to calculate volatility were those derived from his own mark-to-model estimates of intrinsic value. The quantitative fund manager, Mr. Q, took umbrage. If you marked your portfolio to the market, he argues, your volatility would be much closer to mine.

Mr. Q is unequivocally correct. What Mr. P presented is not how the real world works. Mr. P is also correct, however, in believing that public market prices do not necessarily reflect intrinsic value. Mr. Q might not disagree. Thanks to Nobel prize winning economist Robert Shiller, we know public markets are more volatile than they would be if markets were informationally efficient.

None of that justifies Mr. P’s marketing his own calculations of price and therefore volatility. It’s incongruous to have referenced a short-term volatility statistic at all. It’s a hollow definition of risk for an asset class that commands a long-term commitment as equity markets do, public or private. Putting expected returns together with volatility was a marriage of convenience for Markowitz, a concept, wrote Daniel Crosby, that was “bastardized to serve a computational end.”

The danger in not calibrating the volatility in a portfolio to public prices, says Mr. Q, is in understating risk. Yes, it’s dangerous to understate risk. It’s equally dangerous to wrongly define it, likely misprice it, and gain false comfort in the process. Future volatility (and correlations) will feel no moral obligation to look like the past and might fail to do so when needed most. Yesterday’s short-term price variance will do nothing to accurately prophesize that 100-year storm, when correlations become the tail that wags the volatility dog.

Mr. P doesn’t have a monopoly on misleading statistics. Disciples of modern finance have long stretched to defend metrics that serve their own marketing programs. Mr. P’s prices may be make-believe but in pointing out the error Mr. Q draws attention to the hedge fund industry’s own use of the same flawed risk measure generally, and the mythical notion of risk-adjusted returns specifically. Try to take those risk-adjusted returns down to your child’s college to pay the tuition bill. Talk about your false profits.

What of the seemingly irrational need some investors have for entering a long-term commitment to prevent themselves from succumbing to myopic loss aversion? In the endeavor to understand markets, behavioral science is more than a test of faith; it’s the missing link. Mr. Q may optimize his utility like a rational economic agent; most market participants do not. The reality is that equity investor returns would benefit from friction in trading. The data is overwhelming in this regard. But strapping yourself to the mast of a ship like Odysseus trying to avoid the siren song of trading? I would envy the self-awareness.

Are future private equity returns driven lower by investors flooding the market in pursuit of lower volatility? Though the net effect will be the same, it’s just as likely dollars have been increasingly allocated to this asset class in pursuit of the higher historical returns. If not price volatility, then what definition of risk? Illiquidity is still a risk, one that does seem odd to pay for. Leverage adds risk as well. Neither is a good definition of investment risk. I’ll propose two alternative definitions: permanent loss of capital and failing to achieve long-term return objectives.

Permanent loss of capital happens because the investor is forced to sell at a loss to meet current cash needs. If foolish enough to invest money in the stock market that you might need in the next few years (no less the next few months), standard deviation is the risk metric for you. If you can strap yourself to the proverbial stock market mast for a dozen years or more, that equity index fund has always made you money, short-term variance be damned.

Failing to achieve return objectives gets short shrift as a risk factor in the academic world of modern finance, where total return is subordinate to risk-adjusted return. Nearly everything fund managers do to decrease price variance will cost investors total return in the long run, from hedges and market timing to excessive diversification and allocating to lower-returning strategies just because they are uncorrelated. It cannot be otherwise.

That leaves us with the Golden Rule of investing: given a time horizon, invest to maximize total long-term return. Replace mean-variance optimization (a false dilemma anyway) with return optimization. Buffet simplifies it further: “The investment shown…to be the cheapest is the one that the investor should purchase.” Everything else is commentary.

John Emrich is host of the Kick the Dogma podcast and a retired equity fund manager.

Morning Kick February 1

For those of you that subscribe, a new Morning Kick is up on Spotify, Amazon, Apple, and when they get to it, Stitcher and Google. South Korea and Norway in the news, but this Morning Kick is about Inflation, and how difficult it is to calculate or estimate, no less forecast. I don’t know anyone that has a great track record, and if you do, head to Wall Street to trade bonds. That’s your highest and best use.

One of the challenges with the inflation discussion is that every price increase is treated in the news as “inflation” unlike price declines which can be differentiated into disinflation or deflation buckets. And then there are so many measures of inflation, from CPI, trimmed mean CPI, two year CPI, core inflation, and others. There’s expected vs unexpected inflation. Lastly, the government’s calculation of inflation is subject to human adjustments called hedonics, or quality adjustments.

It’s best just to try and invest in a way that generates the returns you forecast whether inflation is 2% or 6%. For instance, stocks will do better than bonds if prices continue to accelerate, and certain stocks will do better than others. Companies with big market share and pricing power will pass on those higher costs and preserve margin. Companies in markets considered “hard assets” like real estate, infrastructure, and base metals will do better. But never forget commodities are not long-term outperformers when compared to the S&P 500. I don’t believe in hedging for hedging’s sake. Your investment case should be that there is a secular tail wind behind those hard commodities, and they’ll give you extra protection should inflation get away from the Fed. There’s more in the Morning Kick, so listen. And share. And email me with things you want to hear about: john@ktdpod.com And thank you!

Intro to “Kick the Dogma: An Investor’s Guide to Breaking the Chains of Modern Finance

“…the discipline of economics has yet to get over its childish passion for mathematics, and for purely theoretical and often highly ideological speculation at the expense of historical research and collaboration with other social sciences. The obsession with mathematics is an easy way of acquiring the appearance of scientificity without having to answer the more complex questions posed by the world we live in.” – Thomas Piketty, 2014

“It is in this spirit that I invite you to examine some of the direct consequences of monotheism on our common history.” – Rodney Stark

This story begins with a Conversation. It is 2005, and I am in a marketing meeting with a prospective client for our hedge fund. It’s an old wealth management firm that allocates to third-party fund managers. The firm is named for the octogenarian in front of me and his brother, not present. They had made a lot of money for their families through this firm, though the brother’s nickname in some circles was “the Great Pretender” for his disproportionate wealth relative to his investing acumen. It’s the guy across the table from me that knows how to compound capital.

We were a new firm with a short track record. But what we did and how we did it we had done successfully elsewhere…