(May 17, 2012) — The financial industry is dominated by bad models, flawed thinking, and excessive innovation, James Montier of GMO concludes.
“For instance, you don’t find physicists betting that a feather and a brick will hit the ground at the same time in the real world. In other words, they are acutely aware of the limitations imposed by their assumptions. In contrast, all too often people seem ready to bet the ranch on the flimsiest of financial models,” GMO asset-allocation team member Montier comments in a whitepaper. “There is much we could learn from physics.”
According to the paper, all financial model underpinnings and assumptions should be rigorously reviewed to find their weakest links or the elements they deliberately ignore, as these are the most likely source of a model’s failure.
Montier outlines the assumptions he views that are intrinsic in the Capital Asset Pricing Model (CAPM), namely that 1) the only “risk” is volatility, 2) illiquidity can be ignored, 3) leverage is freely available and can be deployed without any consequences.
“Those following this model will seek to leverage up illiquid assets,” he notes, referencing the fall of Long-Term Capital Management, which nearly collapsed the global financial system in 1998 due to high-risk arbitrage trading strategies.
Meanwhile, in the global financial crisis, it wasn’t CAPM, but rather models such as Value-at-Risk (VaR) that created problems, Montier says. “Using VaR is like buying a car with an airbag that is guaranteed to fail just when you need it, or relying upon body armour that you know keeps out 95% of bullets,” Montier asserted. “VaR cuts off the very part of the distribution of returns that we should be worried about: the tails.”
Looking ahead, Montier argues that the theory of finance must evolve, as “a little more common sense and a little less complex mathematics would go a long way toward making the theory of finance more sensible.” Additionally, Montier advises that all practitioners should be required to take a financial version of the Hippocratic Oath, with an emphasis on doing no harm.
“We should all treat financial innovation with skepticism,” he advises.
His comments jibe with recent claims by the 300 Club, a leading group of investors, which noted that such theories as CAPM and the efficient market hypothesis contributed to the 2008 financial collapse.
“Harry Markowitz, the pioneer of modern investment theory, was the first person to make risk the centerpiece of portfolio management,” said Professor Amin Rajan, Chief Executive of Create Research and a member of the 300 Club, the group of 10 investment professionals formed to raise awareness of the potential impact of current market thinking.
“This view inspired the origin of CAPM and the efficient market hypothesis, both of which have since dominated portfolio theory. However, the evolution of these two theories led to the inference that markets are efficient and that active management does not work, which is simply untrue.”
According to the investing group, the CAPM argues that by making various assumptions, much of the variation in investment returns comes from market movements, with each investment containing systemic and idiosyncratic risks. Thus, the only reason why an investor should earn more by investing in one stock rather than another is that one is riskier than the other. Furthermore, the group concludes that CAPM not only ignores investors’ behavior biases, but that it also omits other factors that have a significant role in influencing future returns, such as: price-earnings ratios; debt-equity ratios that measure leverage and book-to-market equity ratios.