January 29, 2018

The Bankruptcy of Modern Finance Theory

Outcomes are easy to measure in financial markets: you either beat the index or you don’t. And the results could not be clearer about how few people possess any real skill.

A recent study found that 70 percent of actively managed funds have failed to beat their benchmark index and just 2.3 percent have delivered excess returns of more than 2.5 percent—and those are pre-fee numbers.1 Fees make the picture even worse.

Trying to pick in advance which funds will be among the few that beat the market has proven just as difficult. Morningstar’s famed star ratings have a poor track record of picking winning funds. Brokerage accounts advised by financial advisers achieve lower net returns and inferior risk-return tradeoffs than self-directed accounts. Even the expensive investment consultants who advise the world’s biggest money pools have shown limited ability to pick funds. The academic research now shows that the best metric for picking funds is the expense ratio: the less you pay experts to manage your money, the more you keep.

Very few of the highly paid and well-credentialed professionals that run mutual funds and advise client investments actually add value. Yet clients still flock to actively managed funds and expensive advisers. There is, in finance, a massive calibration error: a gap between claimed expertise and actual results.

At the heart of this calibration error is bad theory. The profession of finance as practiced today relies heavily on modern finance theory: the dividend discount model and the capital asset pricing model. These models are the centerpieces of most business school finance courses, and surveys suggest that they are used by over 70 percent of CFOs for capital budgeting. They are also used by almost every fundamental investor and most financial advisers.

Read more at https://americanaffairsjournal.org/2017/05/bankruptcy-modern-finance-theory/

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