This is the second installment in the Radical Uncertainty in Finance series. The first explored the origins of probability theory.
Commercial considerations determined financial transactions for thousands of years.
Interest rates — and annoyance about them — played a key role even for the ancient Greeks. Double-entry bookkeeping has a long pedigree and came into common practice more than 500 years ago, in Renaissance Italy. Just as the hammer and trowel were the essential tools of the bricklayer, so too were interest calculation and double-entry bookkeeping for the financier and investor.
Then as now, uncertainty was pervasive in finance and investing and common sense was required to navigate it. People learned to differentiate among their investments as a means of reducing the risk of uncertainty-related losses. This meant keeping reserves in cash and other “safe” assets to cushion the blow of unforeseen downside events.
But in the last century, the commercial and commonsense approach to financial transactions and uncertainty fell out of favor. The economists weighed in and ushered in a new era.
A New Era or a New Error?
In the early 1950s, a doctoral student at the University of Chicago named Harry Markowitz submitted a paper with a mathematical procedure to minimize the fluctuation margin — the volatility — of an investment portfolio by cleverly differentiating between individual assets.
Markowitz’s essential contribution was to apply the probability theory developed around the gambling tables of 17th century France to investing. He replaced the commercial approach with a scientific one that purported to transform uncertainty into measurable risk.
To this end, Markowitz redefined risk. Rather than the traditional notion of the potential for loss, risk was transformed into the volatility of returns in an investment portfolio. And Markowitz further assumed that the random distribution of financial prices could be described with the well-known Gaussian normal distribution.
With the birth of modern portfolio theory (MPT), Markowitz not only opened up a new field of research — Modern Finance — for the economic sciences, he also revolutionized the financial markets. Soon William F. Sharpe, John Lintner, and Jan Mossin developed the capital asset pricing model (CAPM) and applied it to the valuation of individual investments based on the entire market.
Then, in the early 1970s, Eugene Fama’s efficient market hypothesis (EMH) claimed that financial prices reflect all available information, and the option pricing theory of Fischer Black, Myron Scholes, and Robert C. Merton* was created and integrated into Modern Finance.
Modern Finance proceeded from theory into practice more quickly than almost any other field of economics. Not long after the option pricing theory was published, for example, Texas Instruments developed a calculator programmed with the formula.
Markowitz’s portfolio theory inspired the development of the junk bond market, the value-at-risk (VaR) model for risk management (and financial regulation), and the notorious collateralized mortgage obligations (CMOs) and their associated subprime mortgages.
The CAPM shaped the thinking and vocabulary of financial market players. The EMH provided the theoretical basis for the increasingly ubiquitous exchange-traded fund (ETF).
The Mirage of Modern Finance
But the huge edifice of Modern Finance, the “superego” of the financial industry, is built on sand. Its foundation is the illusion that the radical uncertainty that prevails in our large, complex, and messy world can be understood and exploited through the calculable risks of a small, simple, rational model.
That the illusion persists despite ample compelling and damning evidence is perhaps Modern Finance’s singular achievement. The financial sector, powered by Modern Finance, has regularly generated financial crises, both large and small. The 1994 bond market crash, for example, blew up the VaR risk management models that had been introduced shortly before. The global financial crisis of 2007 and 2008 then brought a repeat in CinemaScope.
The legendary hedge fund Long-Term Capital Management collapsed in the late 1990s because of an overreliance on the option price theory. Moreover, a straight line can be drawn from MPT, which provided the theoretical basis for CMOs, to the global financial crisis.
The history of finance over the last several generations, with its dot-com bubbles, Black Mondays, and Great Recessions, shows just how close we have come to conquering uncertainty. We are no closer to curing it than we are the common cold.
Which is why we need to reject the mirage Modern Finance projects on the market and revive a commonsense approach to uncertainty.
* Due to an editing error, an earlier version of this article incorrectly listed Thomas Merton among the pioneers of option pricing theory. The text has been updated to correct this error.
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