We Shouldn’t Question. Should We?
I like being an investment advisor. Though sometimes when people ask me what I “do”, I’m not sure what to answer. I’m not sure whether to answer with what I like the best about what I do, or what I feel is the most important aspect of what I do, or whether to answer with some sort of a Zen expression like, “I do what financially needs most to be done.”
But when I get down to really thinking about it, I think my most important function is to force people to question authority… not in a 1970′s bumper sticker or an LSD-laced-
Timothy-Leary sort of way, but more in a Ben Franklin kind of way, “It is the first responsibility of every citizen to question authority.” (Note: It’s probably all the same, but quoting Ben Franklin in a financial article is smarter than quoting Timothy Leary.)
My real answer thus becomes, “I force myself to question the basic tenets and accepted wisdom of conventional investment management theory in an attempt to better our client’s futures in an increasingly sophisticated and less-predictable world environment in order to protect them from unknowable financial risks and to take advantage of as yet unknown financial opportunities.”
But if I’m in an elevator and you ask me, I’m more likely to say that, “I do what financially needs most to be done.”
Which brings me to what this post is about. Even though I have an entire page devoted to scholarly articles that scientifically refute the basic mathematical assumptions of Modern Portfolio Theory, I am always asked something like the following, “How can the entire industry be doing it wrong and you’re the only one doing it right?” Or something like that… you get my drift.
First, I’m not the only one doing it right. But, we are few and far between. So, I get a little bit excited when I find ANOTHER article published in a respected financial journal by a respected financial colleague. This one is entitled, “Is Portfolio Theory Harming Your Portfolio”, and is written by Scott Vincent of Green River Asset Management. It is published here on the Social Science Research Network and I have it listed on my “…for further study” page now also.
The gist of the article can be summed up in this quote from the article:
That these quantitative financial models don’t work in practice isn’t controversial. The theories have been losing the battle in scholarly articles for the last three decades. Even many of the influential researchers behind modern portfolio theory admit to their shortcomings. Markowitz is quoted as describing his book on Portfolio Theory as “really a closed logical piece” – i.e., something that only works in the lab. Eugene Fama called CAPM “atrocious as an empirical model” and said “CAPM’s empirical problems probably invalidate its use in applications” Fama & French (2004). Even the ardent supporter of EMH, Paul Samuelson, noted “… few not-very-significant apparent exceptions” to micro-efficient markets, and admitted the existence of some exceptionally talented people who can probably garner superior risk-corrected returns.
and following…
The real controversy is that, even though its chief architects admit the quantitative theories are ill-suited for practical use, and empirical data confirms it, they are still embraced,(indeed some might say “worshipped”) by operators in our capital markets, and heavily relied on to make important financial decisions. The theories have become so deeply ingrained in our financial system that we can’t see their folly. Their mathematics, as well as the precise nature of their output, gives us a sense of comfort which is critical in deploying large sums of money. They also lead to a misallocation of resources, however, causing giant distortions.
So why not question authority? I believe your biggest investment risk comes from NOT questioning authority.
