A fresh slant on risk and uncertainty
The Economic and Financial Order
The key message of Economic and Financial Order is provocative. The economics behind current investment theory is in a fantasy world and needs to be brought down to earth by re-anchoring it to the field of philosophy. That is in much the same way as was done by its founding father, Adam Smith, in the eighteenth century.
As Pascal Blanqué, the global chief investment officer at Amundi puts it: “It is the contribution of philosophy that allows economics to be liberated from the lack of realism that imprisons it.” In one volume, he synthesises his thinking on a wide variety of related subjects explored in his various scholarly books, essays and articles published over the past decade.
The central character in the book is the ‘Subject’ – the economic agent who makes decisions that influence the way the modern economy and finance work. In real life, this Subject bears no resemblance to its textbook caricature called homo economicus (economic man) – the rational, self-preserving, utility-maximising individual, sitting at the heart of neoclassical economics in general and its modern portfolio theory (MPT) offspring in particular.
The reason is simple: the Subject is not a member of a homogenous species that thinks and acts alike. Instead, it is a creature of its own unique experiences, perceptions, history and habits which, in turn, shape its behaviour. If it displays ‘limited rationality’ within its relationship with the world, that is only because MPT solely focuses on the objective aspects of human behaviour, while excluding its subjective drivers.
In his role at Amundi, the author is well placed to assess how MPT, the cornerstone of the contemporary investment edifice, works in practice. His verdict: the theory is feather light on reality. Its organising assumptions are as fanciful as the tooth fairy.
The book covers numerous topics. To convey their full flavour this review will focus on its two key insights.
• Increased mathematisation of economics has turned it into a discipline that is rigorous about the wrong things. The traditional approach in economics assumes absolute rationality on the part of the Subject, with no reference to time or memory. Everything takes place as if, at each instant, a unique experience determines the system.
This heroic assumption enables economists to apply elegant maths to model human behaviour with all the appearances of rigour. But it ignores adaptive perceptions that the Subject displays in its daily relationship with the messy real world of non-linearity. The bottom line: “economics belongs in the world of perception rather than the world described by science”.
Hence, the author builds a synthesis between economics and philosophy by linking past and present that affects the Subject’s perceptions about the future. His approach progresses from a description of the subject, its norms, the institutions it interacts with, and the notions of justice and morality.
• It is time to inject a dose of realism into MPT. MPT rests on two over-simplified assumptions – security prices depend on the totality of information available at the time about future profits and these, in turn, can be predicted accurately and always influence collective expectations. That way, markets are continually at equilibrium and any unexplained price variations follow a random walk. Thus, the notion of the past is ignored; nor is there any explanation on how the available information is perceived by the Subject, how collective expectations are formed, or consensus reached. The result:
“Reducing the Subject to a figure of absolute rationality…. reduces the notion of risk to that part of uncertainty, akin to the lottery draw that can be measured by the science of statistics and the law of large numbers.”
“The Subject is not a member of a homogenous species that thinks and acts alike. Instead, it is a creature of its own unique experiences, perceptions, history and habits which, in turn, shape its behaviour”
Worse still, the theory assumes that investors select a portfolio at a given time t to produce a return at time t+1. They mostly care about the mean and variance of their one-period investment return. However, this assumption ignores the fact that it is impossible to correctly predict expected returns and their covariance, without a plausible theory of the Subject.
The same applies to the concept of risk. It is presented as an external object of the physical world that the Subject accepts passively without being able to modify it. It gives the false impression that the unknown can be known and controlled objectively in advance.
This is fundamentally different from the concept of uncertainty – something influenced by the psychological experiences of the Subject that link the past, the present and the future.
In real life, the Subject is far more aware of uncertainty than risk; often the word risk is used when uncertaintyis meant. New information is not relevant, unless it modifies long-term expectations based on past experiences. Hence, part of the uncertainty can be reduced by means of a better and more realistic consideration of the Subject, its perceptions and it reality.
Accordingly, the author proposes a four-point reformulation of MPT: substitute the notion of uncertainty for that of risk; replace the notion of returns in their annualised form with returns that are path-dependent; introduce the notion of liquidity, since not all assets are exchangeable at a given time, contrary to what MPT assumes; and adopt multi-horizon, multi-scenario investing.
Blanqué ends on a sombre note: “Our era is suffering from an intellectual crisis which, in any pivotal period, is the source of all that ensues. This conceptual crisis hinders the determination of diagnosis and the selection of tools.”
There is no foregone conclusion concerning the ultimate outcome of such fragilities, apart from the fact that, after a certain point, they can no longer be reversed. They become embedded in the system and morph into yet another wild variable with which investors have to contend.
In a world condensed into a small number of characters, investors are too pre-occupied with the here and now. The news they digest is so condensed in quality and insight that it is hard to understand the deep-seated challenges they are facing. A book such as this is a valuable guide in that regard. It assumes a good working knowledge of economics and finance on the part of readers. It deserves to be read widely.
Amin Rajan is CEO of CREATE-Research and member of the 300 Club. He has jointly authored several reports for CREATE-Research with Pascal Blanqué