Monday, June 8, 2009

“Let’s Suppose” and the “Equals” Sign

It turns out that two of the most destructive forces for the economy are the words “let’s suppose” and the use of the = sign. When we put the two together they form a combustible combination that gives seemingly well intentioned and rational investors the power to disintegrate assets “at will.” This is because investors have a desperate need for quantitative models that will justify and “prove” their investment thesis, if for no other reason than it provides much better job security than having an investment thesis based on their good judgment and common sense. Unfortunately, this state of affairs gives rise to some of the most egregious misuses of the scientific method that one could imagine.

For example, let’s suppose that 8 pumpkin pies = ½ of a new Cadillac CTS. Therefore, 16 pumpkin pies = 1 Cadillac CTS. Why not? As I sit in my office, I suppose that 1 lamp = 1 roll of tape, and therefore if I buy 5 rolls of tape the equation is 5 rolls of tape = 1 current lamp + 4 more lamps. When we “suppose” in order to use an = sign we turn outrageous and silly statements into a scientific formula that sounds persuasive. Let’s try some other assumptions on for size with an = sign to follow. Let’s suppose that investors have perfect structural knowledge, meaning that they know why prices change today and in the future. Let’s also suppose that they have perfect economic foresight, meaning that they perfectly know how current news will impact future prices. Then our equation becomes today’s prices + news = future prices. It may sound impressive, but we might as well be talking about pumpkins and Cadillacs. Assumptions like these must carry a high burden of proof that they are correct.

How about these assumptions? U.S. residential real estate prices never go down in value. Markets always function normally so standard deviation properly measures risk. Investor behavior doesn’t impact markets so price changes can be measured by the same method used to measure the movement of grains of pollen in water (Brownian Motion). Or, the market is always in equilibrium except for the news, investors have the same risk tolerance, the same access to information, the same indifference to taxes, investors can borrow at the risk-free rate….and on and on. These are the basic assumptions used to justify the rational expectations pricing model, which is known to most investors as the efficient markets hypothesis. It is a powerful and troubling example of what happens when the words “let’s suppose” get followed by an = sign. It is usually a recipe for financial mischief of all kinds. Our world is full of quantitative models used to justify investment decisions. Investors must beware of the assumptions in these models.