An important new monograph from the CFA Institute Research Foundation explores a fundamental question in the wake of the global financial crisis: Has finance theory failed investors?
US President Harry Truman once joked that he wanted to find a one-armed economist who wouldn’t be able to hedge every opinion by saying “On the other hand. . . .” In the years following the 2007–09 financial crisis, countless policymakers and investors could well understand Truman’s frustration with equivocating experts. Definitive answers were rare. Fundamental precepts — from macroeconomics to monetary policy to Modern Portfolio Theory — were shaken or even shattered. At times, the loss of conviction and consensus appears to have culminated not in a revolution of understanding but rather in the destruction of any pretense of understanding.
By way of an example, one need look no further than the concept of a “bubble.” To most observers and market participants, the loud popping sound produced by Lehman’s collapse in 2008 and the gummy substance covering the face of the global financial system would seem to be sufficient evidence of a burst bubble. According to mainstream finance theory, however, bubbles are by definition impossible. The very idea of a bubble is nonsensical. In 2010, Eugene Fama, one of the primary architects of the efficient markets hypothesis (EMH), went so far as to say, “I don’t even know what a bubble means.”