What if Einstein Got it Wrong?
Guy Fraser Sampson
If this were this question to be posed by any physicist, the world would sit up and take notice, if only by despatching the questioner to a padded cell in the home for the terminally bewildered. Yet it is precisely such a question which is posed in The Pillars of Finance.
Inspired by Kant, who broke the natural sciences such as physics down into its essential building blocks (time, space and causation), a similar approach is applied to the world of finance and investment and the chosen “pillars” in this case are risk, return, value and time. Alarmingly, when examined at this level it becomes rapidly apparent that just about everything we think we understand about finance is at best a misconception and at worst a dangerous illusion.
Take risk, for example. In 1952 self-confessed maths geek Harry Markowitz wrote what has become seen as a landmark paper on the ability of a mixed portfolio to diversify away risk compared to the alternative of holding a single share. As Peter Bernstein would later write in Against the Gods, “Markowitz had put a number on risk”.
Except that he hadn’t. He had certainly put a number on something, but that something was not investment risk. Markowitz, a mathematician who on his own admission at this time knew absolutely nothing about finance, went out in search of something he could calculate. He never actually adopted the course which various eminent writers had done in the past, namely of sitting down and asking “what is risk?” He just seized upon something which he could calculate, because he was a mathematician and believed that anything which could not be reduced to a mathematical process had no validity as a subject of enquiry.
Incidentally, in so doing he was working in the spirit of a long line of thinkers called Logical Positivists, and the book explores how a consideration of other disciplines, such as philosophy, psychology and history, is essential in arriving at any proper understanding of finance.
This “something” upon which Markowitz seized was the extent to which the historical periodic returns of an investment, or market, or portfolio spread out from the average return. This can be calculated by a measure called Standard Deviation, which in this case is simply a posh way of saying the extent to which the price of a share (though dividend payments need to be taken into account as well) goes up and down over time. Let’s call it by its more everyday name: volatility.
Volatility became the foundation of a huge body of financial theory as other mathematicians built more and more complicated models and formulae upon it. What nobody spotted, however, was that they were building on very shaky foundations. Instead of the bedrock of certainty, volatility provided the quicksand of deception. If Markowitz had bothered to research his paper properly, and read what those prominent authorities had said in the past, he might have realised this for himself. As it was, he simply ignored them, ironically a practice which should have been sufficient to have any “peer reviewed” article rejected out of hand, rather than lauded to the skies and treated as meriting a Nobel Prize.
Key to the objections raised to what might be called the Modern Portfolio Theory view by The Pillars of Finance is the fact that the traditional Markowitz approach views risk objectively, as a quality which sits within any investment and is the same for every investor. The book argues that, on the contrary, any meaningful measure of risk must be both subjective and relative. Subjective in the sense that it can only properly be viewed from the perspective of an individual investor, and relative in the sense that it can only properly be assessed in the light of the circumstances and objectives of that individual investor. The word “assessed” is important, for The Pillars of Finance adopts the traditional view expressed by earlier writers such as Knight, Mises and Keynes, that risk is simply too complex an animal every to be fully understood, and certainly incapable of mathematical calculation.
It follows that the world of finance should be prepared to substitute qualitative assessment, based on practitioners’ judgement and experience, for a hard quantitative approach. This in turn facilitates the sort of subjective approach advocated in the book. The possible objection that such a technique would allow emotional factors to intrude into what is supposed to be a rational process is facile. There is no such thing as the rational investor so beloved of the sanitising assumptions which Finance World forces upon us. Financial data is nothing but a record of human action (to borrow a phrase from Mises), human action is a result of human decision making, and our decision making is both instinctive and driven by cognitive biases which distort our thinking by reinforcing our prejudices and suppressing our doubts.
The message of The Pillars of Finance is stark. Far from illuminating the way ahead back in 1952, Markowitz actually took a wrong turning and led the world of finance and investment badly astray. Most worrying of all, none of its inhabitants yet seem to have realised that not only are they headed in the wrong direction but also that they have no idea where they started from.
With its uncompromising condemnation of current thinking, this could well be the most controversial finance book ever written.
Guy Fraser-Sampson is a Senior Fellow at Cass Business School (London) and is a longstanding senior-level investment professional. He is the author of several books on finance and economics. His latest book The Pillars of Finance is a provocative account of the severe limitations of modern finance, advocating a bold new way forward for the finance industry.