WHITEPAPER

December 13, 2015

The Death of Common Sense: How elegant theories contributed to the 2008 market collapse

By Prof. Amin Rajan CEO, CREATE-Research amin.rajan@create-research.co.uk

Scene setting

The 300 Club believes that modern portfolio theory and practice are failing institutional investors at a time when their depressed funding levels and high covenant risks require smarter ways of investing.

Investor confidence is now at its lowest ebb in living memory. The scale of the losses inflicted by the Lehman collapse in 2008 and the sovereign debt crisis in 2011 are immediate causes, but confidence had been eroding over the last decade.

First and foremost, the buy-and-hold strategy was not working, as equities were outperformed by bonds over a long period; second, nor was the barbelling approach, as actual returns diverged markedly from expected returns for most asset classes; third, nor was diversification, as excessive leverage ramped up the correlation between historically lowly correlated asset classes.

These fault lines gave investing poor press after the unprecedented scale and speed of selloffs in 2008. The prevailing doom and gloom caused a herd-like rush into passive funds, as armchair pundits projected the here-and-now into the future. Rational debate was conspicuous by its absence. It is time for a sombre stock-take.

The 300 Club aims to up the ante by delivering dispassionate analyses of the problems that our industry faces, and the actions that it needs to take. Accordingly, this is the first paper in a new series. It sets the scene for the subsequent papers.

It aims to:
• Describe the modern portfolio theory which has profoundly influenced the thinking of successive generations of investors and policy makers since the 1960s
• Review the empirical evidence produced by independent experts to assess how modern portfolio theory has stood the test of time
• Assess the role that modern portfolio theory played in the great financial crash of 2008
• Highlight the subject areas that need to be addressed, if a vibrant investment industry is to emerge from the ashes of the recent meltdown.

Our narrative starts with Harry Markowitz, the pioneer of modern portfolio theory. His famous paper on portfolio selection was a game changer [Markowitz, 1952]. Till then, there was no cogent theory of investment: only rules of thumb and folklore. Investors of 1952 thought the same thoughts and talked the same language as investors a century previously.

Markowitz was the first to make risk the centrepiece of portfolio management. The novelty of his approach was summed up by his famous insight:

“Investing is a bet on an unknown future… you have to think about risk as well as return”.

He thus inspired the intellectual origin of the two concepts that have since dominated the burgeoning literature on portfolio theory as we know it today: the capital asset pricing model (CAPM) and the efficient markets hypothesis (EMH).

In the CAPM, an investor selects a portfolio at a given time t which produces a return at time t+1. The model assumes that investors are risk averse. When selecting their portfolios, they care only about the mean and variance of their one-period investment return. The model is also called the mean-variance model since investors seek to minimise the variance of portfolio return, given expected return; and maximise the expected return, given variance.

Before long, two other related concepts were invented in the investment landscape: efficient markets and active management. It was argued that by factoring in all known information into prevailing stock prices, an efficient market bears out all the predictions of the CAPM. Thus, based on a priori reasoning, this argument also inferred that active management adds no value: in an efficient market nobody has an information advantage.

The edifice of modern financial theory is mainly constructed around CAPM and the EMH. We review the evidence on each in order to show how they contributed to the current financial crisis.

Our review is deliberately detailed: it aims to show how the evolution of the theory over time has side-tracked into trivia and inadvertently missed the big picture of how the financial markets really work.

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