The Two Towers of Finance

Most fresh graduates from business schools and mathematical finance programs quickly awake to a shocking realization: Very little of what they learned during their studies is applied in the real world. There is a disconnect between the academics and practitioners of finance. Very few practitioners get involved in academic activity, and some academics consider practical experience as beneath them, something that would pollute their credentials.

It is a fascinating state of affairs, without much parallel in other disciplines. Most physicists and many mathematicians regularly get involved in solid applied mathematical projects, often working in laboratories side by side with biologists, chemists, engineers, computer scientists and others.

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If most business/finance schools are not teaching the real practice of business, what is the content of their lectures? The obvious answer is, students are taught the content of their lecturers’ theories and publications — the same books and papers that their lecturers had to publish in order to get tenured. The reader may assume that thousands of books and journal articles in the field of finance surely must be grounded on rock-solid empirical evidence. It would be a false assumption.

For centuries, universities debated the nature of the soul, genre of angels, the hierarchy of people inhabiting the heavens, the age of the world based on Biblical evidence, etc. These are highly formalized and stylized debates, involving incredible intellects like Plato, Aristotle, Augustine, Thomas Aquinas, etc. Their discourse occupied the most brilliant minds in Europe for over a millennium.

Today, the greatest minds seem to prefer other subjects, but this highly formal debate no doubt continues and is very much taught in leading colleges and universities around the globe. Likewise, many financial academics teach their abstract subjects without having worked in the positions that most of their students will apply for and pursue for a living. And because their theories are rarely put to the test by practitioners, many wrong approaches are debated needlessly for decades.

Prof. Campbell Harvey recently concluded that most claimed research findings are likely false in the context of factor models. Another way to reach that conclusion is to recognize that academic models not used by practitioners (the great majority) are likely wrong. Having worked for over 15 years in leading financial institutions, one of us (MLdP) bears witness that a very small number of financial academic models have passed the test of practice.

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But this disconnect is not only detrimental to academia. Businesses would greatly benefit from the rigor and transparency that is expected from academic debate. Businesses are speculative enterprises, specially in the financial arena. And yet financial institutions rarely have people at the top with the mathematical background needed to understand and model the risks involved in today’s complex financial instruments. Sadly, this lack of understanding was used as a defense by many of those managers to explain their decisions leading to the 2008 financial crisis. Instead, regulators could have treated it as a case of professional malpractice.

Investors are the losers in this disconnect between Ivy and Wall Street towers. Profiteers occupy the void. While investors are misled using a variety of arguments, this blog will focus on investment ideas falsely promoted as mathematically sound. These are the ones that abuse the trust created by Science and Mathematics to generate false expectations on the side of investors, a situation recently highlighted by Sir Andrew Wiles.

In other words, even if these investments may be highly profitable and desirable, it is not for the reasons stated or evidence presented. These financial charlatans often present their evidence in the form of a flawed historical simulation (also called backtest). Our readers will surely be aware of hundreds of examples, and so we invite them to let them be known.

[Added 29 Oct 2013:] Robert Baillie drew our attention to an interesting and prescient letter to the editor of Science, dated 9 Jul 1982, written by Wassily Leontief of the Institute for Economic Analysis, New York University (and winner of the Nobel Memorial Prize in Economics in 1973). Here is a photocopy of this letter: Leontief letter.

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