The Problem with Investment Theories
or Why Most Winners of the Nobel Prize in Economics Couldn’t Do Your Job
Every few years it seems that some renowned economist or investment expert is awarded the Nobel Prize in Economics. This prize is usually given to individuals who have introduced the world to some theory that changes the way we think, measure or structure economic data or investment portfolios.
For example, let’s look at two of the most well-known investment theories.
In 1952, Dr. Harry Markowitz was working at the Rand Corporation when he wrote his dissertation titled “Portfolio Selection” that laid the foundation for the creation of modern portfolio theory (MPT). He was awarded the Nobel Prize in Economic Sciences in 1990.
At its most fundamental level, MPT suggests:
- The goal of all investors is to maximize their investment return for any level of risk (as demonstrated by the “efficient frontier”).
- Risk can be reduced by diversifying a portfolio through individual, unrelated securities (asset allocation).
- The theory is supportive of a “buy and hold” investment approach.
Dr. Eugene Fama is a Nobel Prize winning economist from the University of Chicago. In the 1960s he wrote his dissertation that formed the basis for the efficient market hypothesis. He was awarded his Nobel Prize in 2013.
The efficient market hypothesis says:
- Investors make rational decisions.
- Securities prices reflect all available information.
- Financial markets are efficient.
- There are no transactions costs.
- There are no undervalued stocks, and it is impossible to beat the market.
While there’s no question that these Nobel Prize–winning theories are backed by lifetimes of research and number crunching, they fail to take into consideration one variable that is the focus of your practice: human beings.
Markowitz and Fama are, no doubt, geniuses. But most investors, even individuals with huge investment portfolios, usually aren’t geniuses. Instead they are human beings who are often victims of their own biases and emotions—two things that don’t serve them well when they make investment decisions.
Looking at the two theories together, what items can be immediately challenged when it comes to your clients?
- First, speaking about risk within the efficient frontier can be a purely theoretical discussion. But in real life, even clients who understand asset allocation and the concept of the efficient frontier have been known to give the “sell everything” order when the markets go off the rails like they did between 2007 and 2009.
- Second, holding period statistics tell us that investors do not buy and hold. They buy, get impatient, sell and buy something else, often at the suggestion of their financial advisor. Carl Richards coined the phrase “behavior gap” to explain the difference we see between an investment’s return and an investor’s return.DALBAR, which has developed tools to measure investor behavior, found:
Over the 30 years ending 2013, the S&P 500 had a total return of 11.1%. The average stock mutual fund investor earned 3.69%. Accounting for the difference: 1.4% is mutual fund expenses, and the rest is a result of poor timing decisions by investors.
- Third, we know that investors do not make rational decisions. If they were rational, we wouldn’t have experienced the Internet bubble and subsequent dot-com crash or the rise and fall of bitcoin (which may rise and will certainly fall again someday).
- Fourth, Scientific American recently reported that, “we now create more content every three days than we did in the two millennia from the year 1 to the year 2000.” While you may argue with the specifics of their findings, there’s no doubt you will agree that, today, it is impossible for securities prices to reflect all available information.
- Finally, if you disagree with the practical application of the efficient market hypothesis, then it is impossible for you to believe in index investing.
Most of the Nobel Prize–winning theories fail to take reality into consideration. You may want to read the work of Dr. Richard Thaler of the University of Chicago who won the Nobel Prize in Economics in 2017.
You have spent your entire career trying to understand and manage the biases and emotions that cause your clients to make bad investment decisions. Your daily experience underscores the truth in Dr. Thaler’s quote that his greatest contribution to economics “was the recognition that economic agents are human, and that economic models have to incorporate that.”
This material is for investment professional use only.