This is the second installment of the fundamental uncertainty in the finance series. The first explored the source of possible theories.
Financial transactions have been determined for thousands of years by commercial considerations.
Interest rates – and resentment about them – played a key role even for the ancient Greeks. There is a long lineage of double-entry accounting and the Renaissance came into vogue in Italy more than 500 years ago. Just as hammers and trowels were essential tools for bricklaying, so were interest calculations and double-entry accounting for financiers and investors.
Then, as now, there was widespread uncertainty about money and investment, and common sense was needed to navigate it. People have learned to differentiate between their investments as a way to reduce the risk of uncertainty-related losses. This means keeping reserves in cash and other “safe” assets to ward off unforeseen adverse events.
But in the last century, commercial and general knowledge methods have become favorable for financial transactions and uncertainties. Economists have ushered in a new era.
A new era or a new error?
In the early 15050s, Harry Marcoitz, a doctoral student at the University of Chicago, submitted a paper with a mathematical method to reduce the volatility of the investment portfolio.
Marcovitz was instrumental in investing in the theory of probability that developed at the gambling table in 17th-century France. He uses a scientific method instead of a commercial method that speaks of transforming uncertainty into measurable risk.
To this end, Markovitz has redefined risk. Instead of the conventional notion of loss probability, risk was transformed into an instability of return on an investment portfolio. And Markowitz further assumed that the random distribution of monetary value could be described with the well-known Gaussian normal distribution.
With the birth of modern portfolio theory (MPT), Markovitz revolutionized financial markets, not just a new field of research for economic science – modern finance. Soon William F. Sharp, John Lintner and John Mosin developed the Capital Asset Pricing Model (CAPM) and applied it to individual investment evaluations based on the whole market.
Then, in the early 1970s, Eugene Farmer’s Efficient Market Hypothesis (EMH) claimed that monetary value reflects all available data and alternative price theories of Fisher Black, Myron Scholes, and Robert C. Marton * were developed and integrated into modern finance. .
Modern economics moves faster from theory to practice than almost any other economy. Shortly after the publication of Option Pricing Theory, for example, Texas Instruments developed a calculator programmed with formulas.
Markovits’ portfolio theory inspired the development of the junk bond market, the value-at-risk (VAR) model for risk management, and the infamous Collateralized Mortgage Obligation (CMO) and their respective subprime mortgages.
CAPM has shaped the thinking and vocabulary of financial market players. EMH provides the theoretical basis for a growing ubiquitous exchange-traded fund (ETF).
Meraj of modern meaning
But the huge installation of modern finance, the “superigo” of the financial industry, is built on sand. It is based on the illusion that the radical uncertainty that exists in our large, complex and chaotic world can be understood and exploited through the calculated risks of a small, simple, reasonable model.
The illusion that remains, despite enough interesting and disgusting evidence, is probably the only achievement of modern finance. The financial sector run by Modern Finance creates regular financial crises, both large and small. The 1994 bond market crash, for example, blew up VAR risk management models that were introduced a while ago. The global financial crises of 2007 and 2007 brought a repeat to the cinemascope.
Legendary hedge fund long-term capital management collapsed in the late 1990s due to over-reliance on alternative price theory. Moreover, a straight line can be drawn from MPT, which provides the theoretical basis for CMOs for the global financial crisis.
The history of the economy of the last few generations, its dot-com bubble, the Black Monday and the Great Recession show how close we have come to overcoming uncertainty. We are no closer to curing it than the common cold.
That is why the mirage in our market is to reject modern finance projects and revive a general outlook for uncertainty.
* Due to an editing error, an earlier version of this article incorrectly listed Thomas Marton as one of the pioneers of alternative price theory. The text has been updated to correct this error.
If you liked this post, be sure to subscribe Entrepreneurial investors.
All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.
Photo Credit: © Getty Images / Jeffrey Coolidge