Finance Theory Does Not Work
Evidence of little to no application of finance theory in the real world.
I just finished reading the article Why finance theory fails to survive contact with the real world: A fund manager perspective, published in the journal Critical Perspectives on Accounting in 2014.
The author, Les Coleman, now an Honorary Fellow in the Finance Department at the University of Melbourne, focused much of his research on financial decision making by professional investors, trying to improve the underlying theories of investment, a very difficult undertaking. According to his profile page, he eventually ran into a brick wall.
Interestingly though, here he took a turn towards physics, in search of guidance in how that discipline explained dark matter, which led him to publish numerous articles on cosmology and gravity. What an awesome pivot to make, from a successful finance educator and researcher to publishing articles like, Exploratory Analysis of Changes in Global Parameters Around Sightings of Unidentified Aerial Phenomena in Journal of Scientific Exploration in 2023.
Even though an article about UAPs probably entices most more than one about investment theory, I will (unfortunately) only discuss the finance article in this post.
He starts off with a quote, which I too will use (i.e. steal), however I give all the credit to the author:
When a well packaged web of lies has been sold gradually to the masses over generations, the truth will seem utterly preposterous and its speaker a raving lunatic.
(Dresden James, cited by Frankfurter, 2006)
Which I believe states his own belief of where he sees investment theory at the time of writing this article, frames the stance of the article, and it also goes neatly with the below discussed findings of this study.
Coleman conducted 34 semi-structured interviews with professional fund managers across four finance centers, Istanbul (6), London (11), Melbourne (4), and New York (13), during the spring of 2012. He focused on trying to understand fund managers own reasons for not using finance theory or applying investment theory in their decision making.
But before we discuss those findings with the use of quotes from interviewees, let us start by briefly discussing the well-known shortcomings of finance theory.
The author starts off by laying out the debate or dichotomy between finance academics and practitioners, where the ivory tower people (yes I intentionally use this synonym for academics to suggest their disconnect from the real world) don’t take much heed of the practitioners neglect of investment theory, nor that this neglect proves that the theories offers limited value. Hence, they tend to dismiss practitioners as misguided, while the practitioners dismiss the theory as misguided (or unpractical).
One mentioned motive for investors not using the theory is due to its formulaic nature, leaving little room for individual skill, hence diminishing the ‘unique’ capabilities of professional investors. And, the theories are not supported empirically (i.e they do not work in the real world).
The scientific method involves observing behavior, forming explanatory hypotheses, and validating them through empirical analysis. However, much of finance theory evolved as a quantitative discipline with normative theories, not through the kind of descriptive methodology as laid out by Descartes in 1637. To put it in simpler terms, finance theory has little to no basis in the real world.
One of the constraints of forming empirically based theory in finance, is due to the difficulties in monitoring settings where investment decisions are made. If we stop and think of the hierarchy of evidence (or scientific methods) we have:
Experiments (or randomized controlled trials) - highest level of control and can infer causation. We are, at least to my understanding, never at this level in finance/accounting research.
Quasi-experiments - some control, but less than true experiments. Named quasi because they usually lack randomization in selection. An example could be a city which implements a new tax policy in one region, but not in a neighboring region. Researchers compare economic behavior before and after in both regions, but there is no random assignment.
Observational studies - can suggest correlation, but no causation. Think of a study that examines stock price movements and trading volumes across markets during economic downturns using historical data. Observing patterns without intervening, no manipulation, simply data analysis of observed behavior. Usually large-scale and quantitative.
Case studies / Qualitative methods - rich detail, but not generalizable. This is usually where we are, at least in terms of the articles I read and write about. It is at this level interviews sits, for example.
Expert opinion / Theory - Useful but not empirically tested. Modern Portfolio Theory would be at this level of the hierarchy. Because, when it was first developed by Harry Markowitz in 1952 it was a theoretical model grounded in mathematics and logic, not empirical data. However, over time it as of course been tested and subjected to empirical validation, though not outright disproven but real-world data has exposed its limitations.
Okay, now that we have a better understanding of that hierarchical order, it will help us understand the disconnect with the outcomes of the real world and finance theory. Think of most finance theory as developed in isolation from empirical data, and hence at the lowest level in the hierarchy, number 5.
There is obviously a lot more to say on this topic, but I want us to jump into the findings of the study.
88 % of the interviewees make little use of investment theory. The most common reason is that the data are not available to put into the theoretical models. The second most common is that the theory does not work, and yet another reason is that the theory does not include price sensitive information such as management skill, or have the ability to incorporate non-quantitative approaches such as intuition or judgement.
Below are quotes from the interviews with fund managers to color the above findings:
“All data relates to the past: we cannot predict beta and other stock parameters.” (New York long-short manager)
“We can’t estimate future volatility. Looking ahead we guess, based on heavy thought. It is judgmental, not mechanical.” (New York global thematic manager)
“We have dispensed with theory. It took me a long time, but finance theory is a complete distraction.” (New York global thematic manager)
“No matter what tool you use, it is backward looking. Standard deviation, VaR and so on are not good risk measures because you can only calculate historical parameters. We can never know future risk.” (Istanbul equity manager)
“CAPM is of no real use in portfolio construction…” (New York small cap manager)
“We really rely on a personal view and expectations about future conditions. Investment involves our own thinking, culture, and out of the box perspectives: it is almost spiritual.” (Istanbul balanced manager)
“…Quantitative assessments are useful for monitoring, but they have no relevance to my investment decisions.” (London equity manager)
“…The process is a combination, but much more qualitative than quantitative.” (London equity manager)
“Fund managers’ whole belief system is that their judgment is right. Otherwise they couldn’t be an active manager.” (London funds-of-funds manager)
Yes, I probably over used quotes here. But they are really interesting. They give us readers an open window into which we can glance at their thinking, clearly showing the disconnect between theory and practice of investment decision making.
Another quote used by Coleman in relation to the constraints upon fund mangers, which I found really insightful was the following:
“It’s an odd thing about why fund managers sit in buildings with other people. They should be out and about, being creative as part of their job. Sitting in an office just institutionalizes you, and makes you think in fixed ways.” (London equity manager)
In conclusion the qualitative study by Coleman provides rich empirical data on reasons why investment decision makers find neoclassical investment theory —which have been invalidated by real-world data— impractical to apply.
Instead of trying to convince investment professionals to better apply the normative neoclassical theories, perhaps once should start over and set out to observe-hypothesis-test the actual behavior of markets, investors and managers and disregard the old failing theories and build a new theoretical ground for investment decision making. Investment theory requires a change.
Let us end with, according to the author, the most telling statement:
“The portfolio manager puts intuition and feeling into his work: he is not a pilot for the reports or the investment process.” (Istanbul balanced manager)
Reference:
Coleman, L., (2014). Why finance theory fails to survive contact with the real world: A fund manager perspective. Critical Perspectives on Accounting, 25(3), pp.226–236