Mac Murray

On Modern Finance Theory: It Pays to Ignore Your Professors

In DEEP Investing on December 12, 2009 at 3:10 PM

"So, theoretically if I had any money, here's how I would invest it..."

When it comes to wading through the tsunami of academic contributions to Modern Finance (or the fund and banking destruction left in its wake) I cling tightly to the maxim be careful who you listen to.*

Mind you, there are a number of academics I greatly admire for their analytical prowess and explanatory power with regards to the present and past financial crises, for instance  Richard Epstein of the Hoover Institution, Martin Feldstein of Harvard, Simon Johnson and Ricardo Caballero of MIT.

However having something meaningful to say about the national or global economy is one thing; having a clue about generating competitive returns amidst the harsh realities of investment management is another thing altogether.

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Following the admirable work of Benoit Mandelbrot, the “father of fractal geometry” and one of the very few academics I consciously permit to influence my investment management thinking, the foundation of “the house of modern finance” rests upon 3 pillars:

1. the Modern Portfolio Theory of Harry Markowitz (1999)
2. the Capital Asset Pricing Theory of William Sharpe (1964)
3. the Black-Scholes (1973) and Merton (1990) approach for pricing derivatives

Nobel prizes awarded for each ensure the proliferation of these ideas among generations of finance students in schools around the world.

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Mandelbrot’s Shot Across the Bow of Academia

Nevertheless, Mandelbrot’s courageous efforts are shaking the foundations beneath Modern Finance by underscoring two inseparable–and inescapable–facts:

First:   all 3 approaches are primarily based on Bachelier’s original 1900 assumption that price changes obey the Bell curve, the normal Gaussian distribution that drives Brownian motion.

Second:  evidence-based findings reveal that real price movement does not correspond with Gaussian-based assumptions.

You’ll recall from college that every theory is based upon a key assumption.  However if the key assumption is flawed, everything that can be deduced from that assumption is suspect.  In the case of Modern Finance, 4 decades of data reveal a reality which does not correspond with the underlying assumption.

Some 40 years of price analysis reveals the actual distributions fall somewhere between the Gauss and Cauchy distributions.  Since Mandelbrot’s famous 1963 cotton price analysis, the financial industry has accumulated intriguing observations that

1) price changes do not follow a Gaussian distribution but have fat tails

(2) the kurtosis (i.e., the number which tells you how far away you are from “normality”) of  actual data is often significantly higher than the value followed by Gaussian distribution; and

(3) the longer memory effect (that is, the tendency of prices breaking out on high volatility to continue in the direction of the break-out)  contradicts the efficient price theory.

Moreover this data was compiled not merely on cotton, but also wheat, the DJIA,the  S & P 500, Japanese yen/U.S. dollar exchange rate, and deutschemark/U.S. dollar exchange rate data.

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The Moral of the Story?

Simple.  With all due respect to our beloved professors, when it comes to producing competitive returns in the field of investment management, it pays to listen to someone who  successfully manages money.

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“The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis.”

–Roger Lowenstein, author of When Genius Failed

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Thus, the next time professor so-and-so brings up “efficient markets”, your next question should be:

“Sir, how much money are you personally managing right now?”

If the answer is somewhere close to “none”, insofar as your financial future is concerned, it would be safer for you sleep through the remainder of the lecture.

References

Bachelier, L. (1900): Theory of speculation in: P. Cootner, ed., 1964, The random character of stock market prices, MIT Press, Cambridge, Mass.

Black, F., and M. Scholes, 1973, The pricing of options and corporate liabilities, Journal of Political Economy 81, 631–659. Mandelbrot, B. and

N. N. Taleb (2008): “Mild vs. Wild Randomness: Focusing on Risks that Matter.”

Mandelbrot, B. (1963): “The Variation of Certain Speculative Prices”. The Journal of Business, 36(4):394–419.

Mandelbrot, B. (1997): Fractals and Scaling in Finance, Springer-Verlag. Mandelbrot, B. (2001a): Quantitative Finance, 1, 113–123

Mandelbrot, B. (2001b): Quantitative Finance, 1, 124–130

Mandelbrot, 1997 Mandelbot, 2004a, 2004b, 2004c

Markowitz, Harry, 1952, Portfolio Selection, Journal of Finance 7: 77-91

Merton R. C. (1973): “Theory of Rational Option Pricing,” Bell Journal of Economics and Management Science, 4, 141–183.

* based on excerpts from Modeling Maximum Trading Profits with C++ by Valeri Salov

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Be Careful Who You Listen To

E. M. Murray.  Customized Stock Portfolios.  Professional Management.  Fixed Downside Risk.

Customized portfolios. Professional Management. Fixed Downside Risk.

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