So where are all the revolutionary new investment theories?

First half of 20th century saw flood of ground-breaking work; not so much lately

May 21, 2013 @ 12:01 am

By Philip Lawton

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Man at work: Thomas Edison

Investment management is supposed to be built on brilliant minds' novel insights and innovative approaches—or so our training and traditions have led us to believe. We celebrate our best investors, such as Warren Buffett, Peter Lynch, and Bill Gross, and our best financial theories, such as modern portfolio theory (MPT) and the efficient markets hypothesis (EMH). Yet it seems a long time since we have seen true genius or radically new ideas; and, even more unsettling, recent literature suggests that investors of the future may be deprived of the kind of revolutionary thinking that energized the investment profession in the last half-century.

Does the apparent dearth of financial genius mean the investment industry is in crisis? Will the lack of new investment theories lead to mediocre performance? We don't think so. In fact, we believe that the time is ripe for a new synthesis and that, in the interim, progressive investment management firms will continue to explore the possibilities and improve the investment process.

The Role of Geniuses

The Role of Geniuses

We are accustomed to think of scientific and technological advances as the work of individual creative geniuses. Albert Einstein's theories of relativity are, of course, classic cases in pure science, and examples in engineering also come readily to mind. Thomas Edison's perfection of the incandescent light bulb is taken for granted today, but, when Nikola Tesla's development of alternating current generators made long-distance power transmission practical, lighting changed the world by extending the natural day.1 The cultural, economic, and personal effects of these inventions are immeasurable. In Robert J. Gordon's (2000) view, the electric light and the electric motor constitute the first of five clusters of great inventions in the late 19th and early 20th centuries that have shaped modern life.

Likewise, the investment management industry has benefited tremendously from transformative ideas. Notably, MPT, EMH, and the capital asset pricing model (CAPM) were developed by financial geniuses—Markowitz, Sharpe, Miller, Fama, Treynor, and others—whose work in the 1960s and 1970s revolutionized investment theory. The conceptual framework they constructed and the equations they devised have equipped several generations of investment professionals to make sense of the markets, develop powerful analytical engines, estimate fair values under normal conditions, and vastly increase the range of available strategies and instruments for taking on and laying off risk.

But the role geniuses have played in the past is changing, according to Dr. Dean K. Simonton, an expert in the psychology of scientific creativity. Simonton (2013) distinguishes between creative scientists, who come forward with original and useful ideas, and scientific geniuses, who propose ideas that are original, useful, and surprising. Historically, some geniuses have established new specialties, and others have revolutionized existing fields; but, in Simonton's opinion, it is no longer possible for individual scientists—however gifted, accomplished, unconventional, and industrious they may be—either to found or to transform a discipline. He wrote:

Natural sciences have become so big, and the knowledge base so complex and specialized, that much of the cutting-edge work these days tends to emerge from large, well-funded collaborative teams involving many contributors.

In this environment, scientists are merely “tidying up loose ends” rather than blazing new paths.2 Indeed, Simonton suggests that in the improbable event a solitary genius were to get scientists' attention, it is unlikely they would endorse a costly shift to a new paradigm. Such a conceptual revolution generally takes place in a state of crisis resulting from the incapacity of the received paradigm to account for phenomena it can only call “anomalies.” According to Thomas S. Kuhn (1996), “Failure of existing rules is the prelude to a search for new ones.”3

In a cover story on the current pace of innovation, The Economist (2013) recently concluded that pessimistic appraisals may be overblown, and suggested that economic growth in the emerging world might free millions of minds to “share the burden of knowledge.” Tellingly, however, the article reports—and does not dispute—a conclusion reached by Pierre Azoulay and Benjamin Jones: “Though there are more people in research, they are doing less good.” According to The Economist, Azoulay and Jones estimate that the average U.S. research and development (R&D) worker in 1950 added seven times more “total factor productivity” to economic growth than did an R&D worker in 2000. The article suggests that one element in this decline may be the vast amount of knowledge that individuals must acquire to reach the conceptual frontier of their discipline. I submit that Simonton's tidying up is another plausible factor.

The State of the Art

Although the institutional setting is quite different, the investment industry is, in some ways, tracking the natural sciences. There are cracks in the paradigmatic theory of capital markets. Facts do not support it.

In its semi-strong form, EMH represents a textbook world of frictionless markets in which publicly available information zips to rational, tax-exempt mean-variance optimizers who promptly grasp its implications for asset values in the context of their total portfolios. Low latency trading, which reacts instantaneously to momentary variances in mean-reverting processes, approaches this ideal state, at least within the limits of each model's perceptual field. Nonetheless, there is incontrovertible evidence that financial markets are in varying degrees inefficient, and it is widely acknowledged that, individually and collectively, flesh-and-blood investors are at best imperfectly rational.

Exceptional minds have responded ingeniously to important aspects of this situation. For example, alternative approaches to index investment recognize that securities are commonly mispriced, and smart beta strategies exploit persistent market patterns such as the low-volatility anomaly. These new approaches stand to transform the way investment professionals allocate assets. In addition, some of the best minds in the field are investigating a range of macro- and microeconomic factors in pursuit of a more robust construct than standard discount models to explain the equity risk premium. Behavioral finance offers increasingly rich accounts of the biases to which investors are prone; a deeper understanding of their cognitive styles and the stories they tell may lead theoreticians to rethink the industry's valuation models. It is also reasonable to anticipate significant contributions from emotional finance and neuroeconomics in the near future. In short, investment theory may not have entered a full-blown crisis, but fundamentally contrary ideas are in the air, and this is an exciting time for basic as well as applied research.

Will these alternative ideas be embraced? Or, as Simonton and Kuhn suggest, will they be resolutely ignored by established theorists and practitioners? Our experience tells us that many people are reluctant to explore, let alone endorse, new ideas. Some may feel they haven't enough time and energy to appraise the logic of and evidence for novel hypotheses. Others might thoroughly understand the rationale yet more or less consciously shrink from the career risk that accompanies nonconformist thinking. These are comprehensible concerns. Practitioners face relentless demands at work and, often, in their personal lives, and, when economic growth is slow and unemployment high, the loss of a job can be catastrophic.

Nonetheless, investment professionals are ethically obligated to put their clients' interests before their own. Careerism does not trump fiduciary responsibility. Moreover, once published, new ways of thinking are subjected to intense scrutiny—by academics and leading practitioners alike—at a phenomenal pace. We are optimistic that people will become more comfortable with alternative approaches to investing as the new ideas, in their turn, become conventional.

With these notions in mind, what can firms do to foster, or at least recognize, financial genius and healthy innovation in the investment management industry?

Creativity and Group Dynamics

Fortunately, the options are within reach of most firms. Capital markets research requires neither funding on the scale of the CERN collider nor as many contributors as those who took part in the human genome project. Investment management firms organize relatively small workgroups or teams to conduct research in fairly well delineated topic areas such as asset classes. Large firms may additionally have more specialized research units exploring distinct geographical regions, economic sectors, or market segments. However they are organized, many firms' research efforts revolve around security analysis. Let us assume, however, that most investment organizations dedicate some resources and devote some time to thinking about theoretical issues such as identifying, investigating, and exploiting previously unrecognized or under-appreciated patterns of mispricing.

Academics and senior managers concerned with company culture, organizational design, and motivation have thought about the productivity of individuals and groups since the early days of the modern corporation more than a century ago. However, the challenges are all the greater in post-industrial, knowledge-based organizations, and they are especially acute when groups—even small groups—include the smartest and most independent people. Can investment research teams accommodate inventors and iconoclasts? Can truly original thinkers function as members of a team?

The familiar criticisms of assertedly nonjudgmental brainstorming call attention to the potential downside of group dynamics. No longer as fashionable as it once was, this technique for stimulating creativity in teams has not always proven effective because, despite the stated objective of generating new ideas in a safe haven, brainstorming naturally tends toward facile consensus-building. Some participants may fear they'll sound foolish, as original thinkers often do, and their suggestions will be quietly but nonetheless roundly dismissed. Others may keep their thoughts to themselves because they habitually defer to those who enjoy higher standing due to their hierarchical position, publishing record, or social status within the group. The exercise seems bound to end with fist-bumping after the team precipitously settles on the least disruptive rather than the most original idea.

Personalities differ, of course, but many creative people need encouragement, a quiet place, time alone, and, ironically, deadlines. And, far from being nonjudgmental, the workgroup should listen to their ideas critically—listen attentively, but find fault with their logic and evidence. Hugo Mercier and Dan Sperber (2011) do not see the confirmation bias4 as a cognitive defect; they maintain instead that the human mind was made for arguing, and that reasoning itself is primarily a search for persuasive arguments in support of one's position. That's why we're so bad at criticizing our own ideas and so good at finding the weaknesses in others. Argumentative theory compellingly suggests that the proper function of the team is to evaluate alternative hypotheses and solutions. At its best, small group research is an agonistic process, combative but never hostile.

The reticent and deferential individuals who hold back in brainstorming sessions will not be reassured when the firm encourages their teammates to criticize their ideas. However, there are steps senior managers, notably including research directors, can take to establish and maintain a collegial atmosphere. It is most important to ensure that team members have what Mercier and Sperber call “a shared interest in the truth.” In other words, the participants should be concerned, not with winning a debate, but with finding the most promising answer, however outlandish it might sound at first. Moreover, a corporate culture and workgroup ethic that emphasizes interpersonal honesty, trust, and respect substantially improves the likelihood that all participants will openly share their opinions and offer constructive advice. Research directors and, in the best case, leadership coaches should freely guide participants who seek their advice, just as they should help chronic free riders and arrogant, sarcastic individuals understand that some other firm would probably prove more congenial.

The Way Ahead

In a recent talk at a Research Affiliates conference, Bradford Cornell proposed a series of simple economic principles modeled on fundamental physical laws such as the conservation of energy.5 One of those principles is, “Growth in productivity over the long term is limited by the rate of technological innovation.” Innovation that improves productivity is a necessary, and ultimately a limiting, condition for per capita GDP growth. But Cornell emphasized that it is not a sufficient condition; improvements in the standard of living further depend upon the social exploitation of new, more efficient technologies. Cornell was addressing a critical determinant of economic history with his customary rigor and attention to the data, but, simplified and expressed in more general terms, his insight also applies to investors and investment managers. We derive no advantage from better ways of doing things if we don't adopt them.

In our view, a new, principles-based investment theory, one that promises to work as well as CAPM did while accounting for recalcitrant facts about functioning capital markets, is in the offing. We don't know what form it will take—recall that genius is surprising—but we predict that it will emerge from the collective efforts of many gifted, accomplished, argumentative, sleep-deprived thinkers. In the interim, healthy small groups may succeed in discovering specific anomalies, hypothesizing about their causes, conditionally formulating restricted laws, vigorously criticizing them, and publishing their test results. This is not to suggest it's a good plan to leap a chasm in stages; it is merely to recognize the difference between tidying up and making real but admittedly incremental improvements in the professional practice of investment management. While the industry awaits a new synthesis, investors stand to profit from unexploited opportunities as well as the lower costs that may result from operational efficiencies. And they certainly benefit from transparency.

Philip Lawton is vice president of brand management at Research Affiliates. This commentary first appeared on the firm's website.


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