Debunking Standard Finance Theory

By David B. Armstrong, CFA | Jan 27, 2020 | Invest My Wealth, Weekly Market Commentary

Finance Theory does not easily convert into reality or practice, especially for individual investors.

But you really can’t learn finance without making some assumptions…and through two years of an MBA program and three years of the CFA curriculum, I’m familiar with them all.

In 2017, Meir Statman, a professor at Santa Clara University, wrote a book called “Finance for Normal People: How Investors and Markets Behave.” In it, he outlines five academic/theoretical fundamental blocks that drive investing:

1. People are rational.
2. People construct portfolios as described by mean-variance portfolio theory, where people’s portfolio wants include only high expected returns and low risk.
3. People save and spend as described by standard life-cycle theory, where people find it easy to identify and implement the right way to save and spend.
4. Expected returns of investments are accounted for by standard asset pricing theory, where differences in expected returns are determined only by differences in risk.
5. Markets are efficient, in the sense that price equals value for all securities and in the sense that markets are hard to beat.

He’s probably smarter than I am, but I have 20 years of scar tissue and I’ve got some thoughts to share on these five blocks.

People Are Rational

Um, no they are not. Some may be rational, but certainly not all…otherwise no one would go to Vegas and lottery tickets would never exist. If we were, we’d look at the utility of things and all come to the same conclusion. We don’t. People need cars yet some choose a mechanically sound used car while others will spend $85k on a new car. I think my iPhone tells time as well as a Rolex. People make choices based on what they want or think—we can’t rely on them being rational. Same goes for investing. Investment plans can’t be built around assuming all people are rational.

People construct portfolios as described by mean-variance portfolio theory, where people’s portfolio wants include only high expected returns and low risk.

Ah, no they don’t. A lot of investors actually try to construct investment strategies that “grow wealth” rather than to just “make money.” I think there is a lot more to how people ACTUALLY invest than just risk and return. For example, I see people invest in private equity and hedge funds for social status rather than for the ACTUAL portfolio theory. I think it ends up being more for social, cocktail party reasons than for mean-variance portfolio theory. Investment plans can’t be built around assuming all people only consider risk and reward.

People save and spend as described by standard life-cycle theory, where people find it easy to identify and implement the right way to save and spend.

Hah! Are you kidding me? Reference the car analogy in the “people are rational” section. First there is always spending creep, then there is the social aspect of spending money. We are all victims of it, not that it’s bad—money is at its root meant to be spent—but let’s not kid ourselves and believe that people identify and implement the right way to spend and save. Investment plans can’t be built around assuming all people save and spend the right way.

Expected returns of investments are accounted for by standard asset pricing theory, where differences in expected returns are determined only by differences in risk.

Negative. Prices are mostly set by emotion and behavior or supply and demand. For example, the price of Beyond Meat trading at $125/share and a P/E ratio of 299x is not being set by standard asset pricing theory. Investment plans can’t be built around assuming different expected returns are determined only by differences in risk.

Markets are efficient, in the sense that price equals value for all securities and in the sense that markets are hard to beat.

Markets may be efficient, as seen through metrics showing that most active managers fail to outperform their benchmarks (especially hedge funds), but not in terms of price always equaling value. Investment plans can be built around the belief that markets as a whole are efficient, but can’t be built around the belief of prices equaling value for all securities.

Bottom Line

Theory is great in the classroom and for an academic discussion where assumptions have to be made to intellectually work a problem, but in reality, I believe that probabilities, possibilities, simplicity, patience and discipline are the real fundamental blocks of investing.

Keep looking forward,

Dave

Unrelated Side Note – My Week

I’m a new Director on the Board of Directors for The Station Foundation. The Station Foundation (TSF) supports those who quietly serve our nation—the Special Operations warriors of the United States Special Operations Command. Several times a year, TSF executes a series of workshops in their Bozeman, Montana facility to help these men and women restore their priorities and intentions, reconnect to the people and ideas that matter most, and return home with meaning and purpose.

This week, I’ll be mentoring a winter workshop in Bozeman with 20 participants. The facility is purposely remote—there is no cell service or other connectivity other than one land line. As such, I’ll be out of touch Tuesday, January 28th through Sunday, February 2nd. The office can reach me in an emergency, but I wanted to let everyone know in case you reach out to me this week and don’t immediately hear back. I’ll have my Out of Office email reply on for a reminder. As always, the rest of the Team is available for anything you need.

What’s Next?

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