The Abyss Between Value Investing and Financial Engineering Today, to use Benjamin Graham's own words, "Let us mince no words at the outset." (see "The Intelligent Investor," p. 228) What bothers me most about much of the financial engineering literature is that it has become so abstract and theoretical. Heavy duty mathematics, with little regard for the real world. Sadly, even my beloved American Mathematical Society appears to have embraced the use of heavy duty mathematics in finance. See . Consequently, that literature seems to be of little use, if any, to people who manage money for a living. It's gotten to the point where a professional value investor has joked that he and his colleagues should endow chairs in academia to fund more and more professors who espouse the EMH and do heavy-duty financial engineering. The investor has joked that, by having more professors leading students to EMH/financial engineering land, it actually makes life easier for money managers who search for Benjamin Graham-type bargains. Let's also be clear that my criticism comes from someone who, in his own humble view, knows a little bit of higher mathematics. If I see the financial engineering literature as impractical then, maybe I'm not as smart as the authors but then, I won't send them my hardscrabble dollars to manage. Financial engineering people need to ask the fundamental questions: Are our journal publications of any interest whatsoever to real-world money managers? If not, then when do we start to bridge the gap? Consider the following financial engineering assumptions ("Theory") vs. real-world conditions ("Practice"): Theory: N risky assets, assumed to be non-random Practice: All assets are risky, random in number Theory: A "continuum of traders," assumed to be non-random in number Practice: A finite number of traders, random in number In fact, there are times when there are NO buyers to be found! Theory: All traders assumed to be rational and competitive. Practice: The vast majority of traders, plausibly, are irrational "idiots" (see Graham's "The Intelligent Investor," p. 325, where he recounts the incredible-but-true story of Aetna Maintenance Co.). As for all traders being competitive, have you heard of "insider trading"? Competitive with whom? Theory: Market makers are competitive. Practice: Recently, some market makers pleaded guilty under federal indictments of, to put it in the vernacular, being wildly non-competitive (i.e., they took their customers to the cleaners). Competitive? Yes, but with whom? Theory: "Random variables are normally distributed" (this assumption "often greatly enhances the tractability of the models"). Practice: We regret to inform our clients that we lost all your money because the market unfairly handed us a non-normally distributed random variable. In my view, the assumptions in financial engineering are strange. I cannot see how they apply to the real world. Therefore, I would have to recommend that real-world (hardscrabble Ohio and Pennsylvania) people stay away from money managers who use financial engineering techniques. Recall the fundamental result, Somebody's Theorem: In the stock market, assumptions are the parents of bankruptcy. I urge financial engineering researchers to discard all results which are based on ANY assumptions. Simply junk all "theorems," "corollaries," etc., which are based on any assumptions whatsoever. Start from scratch. Homework: Develop a body of procedures, to be called Practical, Real-World Financial Engineering, which have no assumptions whatsoever. Hint: See 1. Graham and Dodd. 2. The Intelligent Investor. 3. What Has Worked In Investing. See also Browne's speech, "Value Investing and Behavioral Finance," on the BGSU Lectures website. Browne was kind to use the word "skeptical" to describe his and his partners' view of academic research in (behavioral) finance. Browne wrote, "My partners and I at Tweedy, Browne have in the past been skeptical of academic studies relating to the field of investment management primarily because such studies usually resulted in the birth of financial paradigms which we believe have no relevance to either what we do or to the real world. A whole body of academic work formed the foundation upon which generations of students at the country’s major business schools were taught about Modern Portfolio Theory, Efficient Market Theory and Beta. In our humble opinion, this was a classic example of garbage in/garbage out." In this lecture, I shall argue that it may be reasonable to replace the word "skeptical" by "humbug, balderdash, claptrap, hokum, drivel, buncombe, imposture, or quackery." I'll explain later from where I got these words. An insidious consequence of financial engineering The financial engineering literature is replete with results which begin with statements similar to, "The stock market consists of n risky assets. Let p_i be the proportion of our funds which we put into the i-th such risky asset. ..." They then note that (p_1,...,p_n) is a vector in the "open unit simplex," which is mathematical jargon for saying that each p_i is strictly positive and the sum of all the p_i is 1. When statements like this are transferred to the real world, it means that the FE folks are prepared to put a portion of their funds into trading each and every stock, regardless of the individual nature of the n stocks in the market. Imagine that you go to a restaurant and are told that they'll cook anything, everything! They tell you that, even if the carrots are rotten, they can make a great carrot bisque out of it; ditto for rotting veal and fantastic osso buco. Would you eagerly run to a table and say, "Gimme some of everything!"? If you would, then what does it say about you? At best, it means that you're gullible. At worst, Antonin Careme and Julia Child both would view you in a strange light. The FE crowd, by adopting hypotheses which imply that they're willing to trade ANYTHING, open themselves to the charges that they: 1. Are unwilling or unable to distinguish between sensible and nonsensical economic enterprises, aka "stocks" of publicly owned corporations. 2. Fully subscribe to The Greater Fool Theory: We may be idiots to put a positive proportion of our portfolio into Enron, but we can find A Greater Fool to whom we'll trade it a profit. The FE crowd may reply that they're going to allow the p_i to be negative, meaning perhaps that they'll sell short or put a negative proportion of their portfolio into stock #i. (I can see their new theorems coming.) My response will be: Without a case-by-case, fundamental analysis, how will you know which p's should be negative and which should be positive? How will you know what to sell short without doing a case-by-case fundamental analysis? Consider the now-infamous case of Enron (the high-tech stocks have been dealt with in previous lectures). The FE crowd deserves a lot of the blame for the foisting of Enron's stock on a gullible public. By being willing to trade/speculate in anything, they make it easier for Enron-types to maintain a facade far longer than a fundamental analysis will permit. In short (no pun intended), FE may well encourage fraudulent corporate operators. I'll bet that not one of the 10 value funds listed in Lowenstein's "A Perfect Storm" article owned a single share/bond of Enron. Digging into the financial engineering literature beyond the abstract assumptions, I noticed that, deep in the middle of an abstract theorem, they'll suddenly make a comment about a related real-world item. For instance, in one book I read this week, the authors repeatedly served tantalizing hints to the reader in the form of real-world data on the dollar value of American put options traded in 1994, etc. Time after time, real-world data were interlaced with FE theory so as to keep the reader's tongue hanging out in the hope that concrete stuff was just around the corner. As for the Efficient Market Hypothesis, I'll leave it to you to read Whitman's incisive and trenchant observations (see the BGSU Lectures' website) and the comments by Browne and by Lowenstein-Klarman. Still, the tide may be turning. I find very interesting the recent book, J.R. Thompson, et al., "Models for Investors in Real World Markets," Wiley, 2003. These authors begin their treatment of a company-by-company stock with an analysis of the company's balance sheet and financial ratios in the spirit of Benjamin Graham. They next proceed to apply SDEs to assess the variability of the company's stock price. So Thompson, et al. are willing to eat at only the finest restaurants, and then some! The FE crowd has a lot to learn from this book. It seems to me that too few members of the FE crowd are aware that the money managers they influence may be handling the sweat-and-blood-saved money of little people. Too many of the FE crowd are assembling abstract theorems with insufficient concern for the possibly fraudulent practices which may be enabled by their mathematical analyses. In a sense, it is a kind of arrogance to put out stuff which is written, some would say deceptively, to suggest links with the real world. It even suggests a lack of concern for truth; not that their stuff is completely false, but no overriding concern for the kind of truth which will prevent the fraudsters from floating stock onto the markets. Speaking of a lack of concern for truth ... Recently, I bought and read a short book by Harry Frankfurt, an emeritus professor of philosophy at Princeton University. I noticed resemblances between Wall Street/FE and some behavior described in his book. Let's turn to a short movie containing an interview of Prof. Frankfurt. By means of this movie, you'll see resemblances between some aspects of FE and "buncombe." Here we go: http://www.pupress.princeton.edu/video/frankfurt/Entire.mov Frankfurt notes that bullshit and arrogance go hand in hand. "humbug, balderdash, claptrap, hokum, drivel, buncombe, imposture, or quackery" all come from Frankfurt's book. Penultimate point: Why, then, should students study FE? Well, maybe you shouldn't. But I think we actually need some students to learn the language so as to be able to separate chaff from wheat when they go into the professional financial workforce. In order to repel the worst of the FE stuff, you at least have to be able to talk their language in order to convert them from The Dark Side. Conclusion: I close with some ageless comments of Benjamin Graham from "The Intelligent Investor." p. 37: "The work of a financial analyst falls somewhere between that of a mathematician and an orator." p. 147, "... it may be said that security analysts today find themselves compelled to become most mathematical and 'scientific' in the very situations which lend themselves least auspiciously to exact treatment." And a warning: p. 321: "In fourty-four years of Wall Street experience and study I have never seen dependable calculations made about common-stock values ... that went beyond simple arithmetic or the most elementary algebra. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience, and usually also to give to speculation the deceptive guise of investment."