Moment of reckoning
The 300 Club, a grouping of leading investment professionals, believes that modern portfolio theory and practice are failing institutional investors at a time when depressed funding levels require smarter ways of investing. It has issued its first paper, The Death of Common Sense, written by Amin Rajan, a member of the 300 Club and a regular contributor to IPE. We asked him some questions
IPE: Are elements of capital asset pricing model (CAPM) and efficient markets useful for a practitioner’s understanding?
Rajan: The CAPM and, its intellectual twin, efficient market hypothesis (EMH), aimed to provide a simple framework for discussing how financial markets work and what determines stock prices. Earlier tests in the 1970s and the 1980s found both deficient in various respects.
Yet, from the practitioner’s perspective, they retain a hypnotic appeal. For example, CAPM was the first model to stress that risk is a bet on an unknown future. It was also the first to draw the vital distinction between systemic and idiosyncratic risks, highlighting the risks that can, or cannot, be diversified away. In today’s world where risks spring from unexpected quarters, this insight is more valid than ever.
Likewise, EMH was the first to argue that markets are hard to beat and active management has little role. Paradoxically, this proposition has come closer to reality, despite its heroic assumption that individual investors form expectations rationally on the basis of perfect information. This presumed ultra rationality has been refuted in the studies in behavioural finance, which showed that investors often suffer from a herd mentality that make them do things contrary to their best interests.
It is clear that markets are hard to beat not because they are efficient, but because they are unpredictable.
IPE: There are few ‘pure’ proponents of efficient markets left. How do we avoid stylising the debate as a simple pro-contra?
Rajan: The debate has been about how markets work at a nuts-and-bolts level. At the deeper level, however, the debate has been about how they ought to work. Not surprisingly, the proponents of CAPM and EMH have strong leanings towards the Chicago school of economics which believes that the invisible hand of the market is more effective than the visible boot of the state in pricing and allocating resources. They ignore the Keynesian notion of ‘animal spirits’ as the driver of financial markets. Doubtless, this debate will continue as a part of the long standing doctrinaire feud between the monetarists (right) and the Keynesians.
Fortunately, the real debate has moved on without ideological undertones. A synthesis is evident with the recent emergence of The Adaptive Markets Hypothesis. It argues that individual investors are hardly capable of the kind of rationalisation assumed by the EMH. Rather, they learn by trial and error in order to develop some simple rules of thumb that work for them. Potentially, this is a fruitful area: we shall doubtless hear a lot more about it in the years to come.
IPE: Concepts like ‘risk-free’, which underpins Markovitz’s concept of the efficient frontier, are embedded in regulation like Solvency II and the Basel capital accord, while mark-to-market accounting, which assumes fair asset-price values at any given time, is likewise embedded in accounting rules. Can we realistically deprogram this ‘legacy software’?
Rajan: Your question goes to the heart of my paper. My concerns about CAPM and EMH are not so much about which bits of them work and which ones don’t. That’s long been a side show. Rather, they are about the profound influence that CAPM and EMH have had on the policy makers and their regulators.
The extreme volatility in the markets since 2000 has created a huge amount of ‘noise’: stock prices no longer reflect the fundamentals at a given time. Yet, the mark-to-market rules are crafted in the belief that they do. This is not so in this age of deleveraging, globalisation, and high frequency trading. Such market drivers are alien to the EMH. Likewise, with the notion of risk-free rate in Solvency II: there are no ‘risk-free’ assets. History is littered with sovereign defaults since bonds were invented.
To its credit, the 300 Club is seeking to promote a debate on how we can create some fresh thinking without throwing the baby out with the bath water. Mine is the first paper in a new series. The subsequent papers will highlight areas where fresh thinking is vital.
In an earlier response to my paper, Patrick Rudden of AllianceBernstein makes a plea that we should not knock the EMH because investors have moved on and adopted various refinements. I agree.
As I argue in my paper, it is too far-fetched to single out CAPM or EMH as the main culprits in the current crisis. They were merely ingredients in a rich stew of financial irresponsibility, political incompetence, and skewed incentives. The world of investing is too complex for a few theories to bring it to its knees.
However, these theories have indirectly influenced the psyche of financial investors, policy makers, regulators and investment industry - with overall results that are detrimental to the interests of the end-investor.
IPE: Similarly, how do we avoid ‘groupthink’, in which similar hypotheses become embedded in the future?
Rajan: For too long, investment professionals have taken a back seat and let academics run the debate on how financial markets work. Most notably, the academic debate on whether the EMH is a sound concept missed out a much bigger issue - namely, in a world awash with liquidity, to what extent can behavioural biases of investors cause market contagion with disastrous consequences for the global economy?
Working at the coal face, investment professionals need a voice in this debate. That’s why the 300 Club has been created. It aims to provoke fresh thinking at a time when conventional thinking on investing has been found wanting.
In the last decade, actual returns diverged markedly from the expected returns for most asset classes, thus reducing the efficiency frontier to a theoretic concept.
IPE: Have economists tried to establish their discipline up as a quasi-natural science and therefore constructed ‘natural laws’, such as the efficient markets hypothesis, to underpin their belief/desire?
Rajan: Yes. And it hurts to admit it, since I’m an economist by profession.
People who introduced mathematics into economics did it with the best of intentions. But over time some economists got over-excited with their new toys, and ended up creating models that were far removed from real life. To be fair, these new models provided a useful way of thinking about an ideal world. They also always spelt out the assumptions behind their newly minted creations. But desperate for a framework for analysing how markets actually work, their readers ignored the fine print. Worse still, just as many simply relied on in-depth recycling. Many influential people have never read financial theory and yet have no trouble trotting out concepts like rational expectations, systemic risks, risk-free rate, and efficient markets in policy papers and public statements alike.
The economics profession is gripped by a sense of deep introspection. It needs to go beyond clever sound bites if it is to regain its credibility.
The Death of Common Sense, by Amin Rajan, is available from the300club.org