Is a Rejection of Classical Finance Justified? – ValueWalk Premium

Is a Rejection of Classical Finance Justified?

Einstein’s theory of relativity advanced Newtonian physics. That did not mean Newton was wrong – only that his theories could be improved upon. In an ambitious new book, the economist Andrew Smithers rejects core “Newtonian” principles of economics, replacing them with radical departures from conventional wisdom.

But as I will explain, unlike Einstein, some of Smithers’ theories fail meet the standard of empirical verification.

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Looking at the world from a different angle

Sometime in the early 1970s, the comedy troupe Firesign Theater recorded an album called “Everything You Know is Wrong.” It was a satire on “new age” thinking: Dogs flew spaceships! The Aztecs invented the vacation! Men and women are the same sex! Aliens are living like Indians in an Arizona nudist park.

You get the idea.

Smithers’s new book, The Economics of the Stock Market, presents bold and provocative theories that advance our understanding of financial theory. But there are moments that are reminiscent of Firesign Theater – at the extreme, leading one to believe that everything one knows about the stock market is wrong. Here’s Smithers channeling Firesign:

  • The expected real equity return is stable, at 6.7%, no matter what is going on in the bond market.
  • The risks of equities “fall sharply as the time horizon lengthens.”
  • Bond yields fluctuate “within narrow ranges.”
  • Companies don’t try to maximize profits.

It's easy to dismiss these sweeping statements that contradict our understanding of markets. But it’s not easy to argue with a man who “in 1956… went up to Clare College Cambridge to read economics,” and who has been thinking about economic principles and putting them into practice for more than 60 years. Smithers is eminently qualified to question the tenets of neoclassical economics as it has been applied to finance in those 60 years, and he does so in an exemplary way: no math, crystal-clear writing, and a rich vein of data graphics.

Classic finance is still correct and relevant – mostly

Smithers’ central thesis is that companies try to maximize their stock price, not profits. Because of the structure of top-executive pay – “pay them in stock,” the legacy of Harvard Business School professor Michael Jensen – companies almost certainly favor maximizing the stock price over some other measure of profit when there is a choice to be made. (I will argue that classic finance is correct in asserting that the stock price is usually the best measure of long-run profit expectations, so that paying executives in stock is appropriate – unless the pay levels get out of hand, a separate issue.)

Smithers then uses this observation to try to overturn classic finance, the work of Harry Markowitz, William Sharpe, Franco Modigliani, Merton Miller, Fischer Black, and Robert Merton.

He fails in that effort.

Smithers does what many critics have done when faced with evidence that their theory doesn’t fit the facts: He seeks to overturn the whole thing. In place of classic finance, Smithers proposes a blend of Keynesian thought (consistent with his Cambridge education) and behavioral economics.

It’s a seductive proposition but doesn’t quite work. As I wrote in a 2014 essay, “Read Your Sharpe and Markowitz,” published by the CFA Institute,

Some of [the] findings [of the long list of pioneering scholars] aren’t exactly right. [But] classic finance forms a base case or null hypothesis against which empirical facts, new theories, and conjectures can be tested. Without it, we are lost. With it, we have a set of very useful guideposts, a little like Newtonian…physics.1

Newton’s theory of gravitation ignored air resistance. That is not a bug but a feature. It says how gravity would behave in the absence of any complicating factors, air resistance being only one. It’s a point of departure for a richer physics that does account for air resistance and any other frictions you encounter in real life. Without Newton, Einstein would have gotten nowhere.

And, while we may adopt some of the ideas suggested by Smithers in crafting a practical model of investment markets that includes “air resistance” – the frictions of living in an imperfect world – the baseline theories of classic finance are correct. We should learn them thoroughly before trying to identify the relevant exceptions.

Read the full article here by , Advisor Perspectives.


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