Wildness Lies in Wait

Posted Dec 4, 2008 | Dr. Robert Brooks

The purpose here is to provide an academic perspective on the credit crisis of 2008. The goal is not another academic opining on the cause of the credit crisis, rather to opine on the role of academic thought on the crisis. In particular, one lesson from the credit crisis of 2008 is the need to develop a clear language for expressing the level of confidence in financial estimates.

By the end of World War II, severe financial loss had been experienced frequently, but there lacked a rigorous, analytical language. The economic cost of depraved human behavior had been paid regularly but was not well articulated.
Public schools permitted prayers and habitually provided daily Bible reading. Culturally, there remained a heavy emphasis on values-based decision making. People understood that life is filled with uncertainties and many managed their financial affairs with a deep respect for the fragility of wealth.

In the post-World War II environment, the “conservative” corporate manager was desired and rewarded. The academic study for professionals entering the financial services industry was descriptive and primarily a study of human behavior. Bankers followed the 3-6-3 model: pay 3 percent on deposits, loan at 6 percent, and be at the golf course by 3 p.m. Bankers focused on the character of each borrower and were generally profitable. Corporations were often family controlled and common stock was primarily held by households. Approximately 90 percent of equity was held directly by households in 1952, according to the U. S. Statistical Abstract. By 2006, the number was approximately 25 percent.

The academic focus for business students was based on values, that is, what ought to be as opposed to being based on data or what is. Bankers’ primary focus was on credit analysis and portfolio managers studied Graham and Dodd’s Security Analysis (1934) as well as John Burr Williams’ Theory of Investment Value (1938), both heavily focused on acquiring a deep understanding of the fundamentals for each company.

Therefore, there was some direct accountability in corporate management to shareholders, there was a personal relationship with bankers, and portfolio managers were focused on business fundamentals.

The philosophical winds then began to shift ...

In 1953, Milton Friedman published The Methodology of Positive Economics making the strong case for focusing on positive economics (objective data) as opposed to normative economics (subjective values). This train of academic thought facilitated the explosive growth of data- driven finance. Today it is difficult to assert a finance perspective absent historical data. Therefore, a finance perspective that lack historical data remain in the dark. This sheds some light on the frustration with the current crisis because the amount of data available is below our appetite for it, particularly where once liquid markets have evaporated.

In 1959, Harry Markowitz published Portfolio Selection: Efficient Diversification of Investments where he illustrated how to use data to measure the tremendous gains from focusing on diversification. The combination of the advances in computers and the emerging quantitative methodologies made a compelling case for portfolio diversification. Hence, fundamental analysis seemed worth considerably less because one could find the optimal portfolio using strictly historical data and quantitative analysis.

The need for understanding human behavior seemed to be diminishing. The intellectual debates between the theist and secularist views of humanity seemed uninteresting and not particularly relevant for understanding financial markets. Optimal portfolio theory planted the seeds for the explosive growth of the mutual fund industry.

In 1973, Fischer Black and Myron Scholes as well as Robert Merton published path-breaking research related to option pricing models. These papers laid the ground work for advanced financial quantitative modeling. Valuation models were grounded in the physical sciences and were based on physical observations such as the behavior of pollen floating in water and being bombarded by molecules (Brownian motion and stochastic calculus). The language for articulating financial risk emerged from this physical sciences research. The language has so advanced now that there are professional exams and certifications addressing financial risk subject matter. These exams, however, do not seek to have the emerging professionals wrestle with the inherent aspects of human nature.

Peter Bernstein, in his 1996 book Against the Gods proclaimed a new era when it comes to facing the financial future. Financial uncertainties have been harnessed and we have achieved a “mastery of risk.” In fact, we no longer have to walk humbly before God, rather we have “... the ability to define what may happen in the future and to choose among alternatives.” Hence, “professional” financial managers supposedly have a clear understanding of future financial risks and there is pressure to be “aggressive,” thus highly leveraged.

One lesson from the credit crisis of 2008 is that the academic finance community needs to develop a clear language for articulating how cloudy one’s understanding of future financial uncertainties really are. If, as Nassim Taleb suggests in his 2001 book Fooled by Randomness, “history teaches us that things that never happened before do happen,” then financial decision making based solely on historical data is flawed. It may be profitable to re-examine values-based economic ideas and explore alternate views of human nature. G. K. Chesterton in his 1908 book Orthodoxy put it this way: “The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.”