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.