Give Back the Nobel Prize, Professors

Investment opinions are a dime a dozen. What matters in investing is whether or not the talking head has his money invested in an idea. To the Securities and Exchange Commission, typically salaried employees newly graduated from law school who are spending all their money on new suits and are fortunate enough to have a federal pension so needn’t worry about their future like the rest of us do, talking your portfolio is considered a conflict of interest. Certainly, when a mad money hedge fund manager calls his friends at CNBC to talk up a stock while at the same time dumping his shares into the market demand that the TV show creates, there is an integrity issue with both the manager and the TV program in question. However, the managers that I respect most invest their own money in the funds they are managing. It helps concentrate their focus. It simply makes more sense to invest with a particular investment manager if he or she is invested along with you. The opinion of a forecaster who thinks the market has bottomed but has his own money locked away in bank certificates of deposit is suspect, to say the least. Don’t listen to what the talking heads say. Watch what the smart money does.

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The smart money ignores what is taught in most business school classrooms.

Forbes columnist Ken Fisher’s company has more than 20,000 high net worth clients. He now stewards over $40 billion of their savings. Fisher admits to being actively biased against Stanford University business school grads, even though Stanford sits next door to his Woodside, California home and headquarters. Uber-investor, Warren Buffett, didn’t build the Berkshire portfolio by indexing it. The only reason that hedge fund moguls like Ken Griffin, Steve Cohen, and Paul Tudor Jones want to know the composition of the benchmark index is so that they can game it, beat it, and take advantage of those who blindly invest based upon it. While the academic community loudly beats the drum of indexing (buying and holding a broad portfolio of stocks based on their relative weights in a third party “index”), increasingly the so-called smart money is moving toward active portfolio management strategies and away from what is taught at the universities.

Down the hill from Fisher’s sprawling office complex in Palo Alto, California, Stanford University boasts twenty-seven faculty members who have won the Nobel Prize since the university was founded, including sixteen still living Nobel Laureates, many of them who won the prize for their work in economics. Though Stanford has one of the best economics departments in the nation, with a faculty second to none, most investors would be better off subscribing to Forbes Magazine for a decade if they want to become knowledgeable investors. Though going to college is incredibly important, the value of what is learned in the college classroom is questionable in any vocation, and in economics this fact is aggravated by the fact that so much of what has been learned during the past forty years has been rubbish. A quick walk down Stanford’s Hall of Greats leaves you scratching your head and wondering what in the world the Nobel Prize Committee could have been thinking. Then again, if a camel is a horse designed by a committee, maybe we shouldn’t be too surprised.

• Kenneth Arrow

Kenneth Arrow, Stanford’s oldest living Laureate of the economics persuasion, was recognized in 1972 for his work on general equilibrium analysis. Arrow’s worked focused on specific products or industries and tried to determine the optimal combination of economic factors (price, supply, wage and material inputs, etc…) to produce a result where changing any factor, though it might generate gains for one individual, will hurt others by more than the gains received by others. In this “Pareto Optimal” solution, though perfection may not be reached, at least things are as good as they could ever get.

Done right, this mode of thinking requires unusually complex numerical computation, which is right up the computing alley of a school sited at the epicenter of Silicon Valley. In fact, it is so difficult to test the math behind these models that it wasn’t until the 1970’s that computing power had advanced to the point where some of the models could be tested using real world statistics. Not coincidentally, that’s about the time that this branch of economics started losing proponents. Over time, Dr. Arrow’s own work began focusing on the shortcomings of the theory, since there was so much more to write about if you changed sides of the table.

The first thing to broadside the theory was the Achilles Heal of almost all economic work, “the assumptions” required to create the model in the first place. General Equilibrium Analysis assumes, for example, millions of perfectly efficient markets that all roll up into a final product. You don’t just have a market for a Yugo. There’s the market for the Yugo’s drive shaft, steering wheel, tires and rearview mirror. If any of these items are bundled together and bid out as a package, efficiencies that could result in Pareto Optimality can be lost. The theory assumes away the possibility of economies of scale so that your new online bookstore start-up is assumed to really not be at any disadvantage to a colossus called Amazon.com. This assumption makes the world much easier to model, but isn’t very realistic (in case you’re thinking about putting some money into the idea).

Arrow’s theory also assumed perfect knowledge among all market participants, which we now know (thanks to the 9/11 tragedy and subsequent intelligence mistakes made prior to the U.S. invading Iraq) just ain’t so! We might as well just assume we’re all rich, and avoid the tiresome steps required to actually accumulate the wealth. As in the great movie “Field of Dreams,” spend it and the money will come. On the other hand, this hasn’t worked out all that well for the sub-prime borrowers and lenders who actually adopted that mantra during the real estate boom.

Arrow also developed “Arrow’s Paradox,” which looks at the potential for developing a voting system that would accurately weight the preferences of two or more people, given three or more alternatives. Arrow proved that no voting system could effectively provide an end result which would be pareto optimal. No democratic method could be designed that would result in a perfect outcome. The outcome of his paradox was that the best solution would be one imposed upon the entire group by a single decision-maker, hopefully of the benevolent persuasion, who could enforce an optimal decision. In non-mathematical terms, his theorem states that no voting method is fair, every ranked method is flawed, and the only voting method that isn’t flawed is a dictatorship.

The only problem with the conclusions drawn from Dr. Arrow’s rigourous mathematical proof is that the real world has proven them to be false. Dictators don’t implement optimal solutions and the freedom of choice for rational adults, when withdrawn, is almost always a mistake. Poor assumptions, wrapped in convoluted mathematical equations, lead to pretty useless conclusions.

As we assume in the investing world, “reality matters.”

Next post: A Prize For The Most Useless

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Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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