My Amazon Review of Andrew Lo's and Stephen Foerster's "In Pursuit of the Perfect Portfolio:........."

 

Thinking About Retirement Portfolios

 

Finance professors Andrew Lo and Stephen Foerster have given us a tour or modern finance theory through the lives and ideas of its leading academics and practitioners with the goal of coming with a “perfect” retirement portfolio. He starts his intellectual history with the mean-variance work of Harry Markowitz and then goes on to discuss the “betas” of Bill Sharpe, the efficient market hypothesis of Eugene Fama and the options pricing world Black-Scholes/Merton. We also have Jeremy Siegel who’s “Stocks for the Long Run” became the bible of the 1990’s bull market, yet Siegel did call the top in the NASDAQ in early 2000.

 

His practitioners are index fund founder John Bogle, pension consultant Charles Ellis and bond guru Martin Leibowitz. We also have the behavioral economist Bob Shiller of irrational exuberance fame. In the interests of full disclosure Marty Leibowitz was my boss for a time at Salomon Brothers and I worked with Myron Scholes there as well. I also first met with Bob Shiller at the infamous Fed meeting on the stock market in 1996 where I was a participant.

 

What all of them had in common is that they were math “nerds” as kids. Further something must have been in the water at the University of Chicago and M.I.T. in the late 1960s. It was at those two places along with Sharpe’s UCLA that modern portfolio theory exploded on to the scene. For my perspective I received an MBA from UCLA in January 1966 in finance where modern finance was barely discussed and four years later when I returned for a Ph.D. in finance it was all that was discussed.

 

So, what is an investor contemplating retirement to do? The general consensus is that there is no generic retirement portfolio. It depends on the individual investor’s tolerance for risk and consumption patterns. Within that framework nearly all of them would recommend low-cost index funds and TIPs. There is some support for the traditional 60/40 stock bond portfolio, but Siegel and Ellis are skeptical of bonds when interest rates are extraordinarily low as they have been for the past several years. However, this presents a quandary, if bonds can be over-priced why can’t stocks be and vice versa. This is where Shiller’s cyclically adjusted price earnings ratio might be a tool to be used qualitatively.

 

Several of them recommend adding international stocks through a low-cost index fund, small cap stocks and value stocks to the mix. Although this was certainly theoretically sound around the turn of the century, over the past two decades those substitutions within an equity portfolio would have severely detracted from investing the S&P 500 alone.

 

My criticism of the book is that it gives to great a weight to the concept of efficient markets. While the markets are efficient most of the time, that is always not the case. Witness the recent collapse of high value-money losing companies as an example. The authors mention the term “black swan,” in passing, but they do not mention Nicholas Nassim Taleb who popularized the term a decade ago. This omission is unfortunate because Taleb is one of the keenest critics of modern finance theory. Simply put the tails of return distributions are much fatter than in a normal distribution and the probability distributions are not stable over time. Moreover, we know our lives are path dependent, why shouldn’t markets be path dependent, at least, in some cases and especially when the economic regime changes.

 

Although cited, the 1900 dissertation by Louis Bachelier in Paris, should have been given more emphasis. As mentioned, Bachelier anticipated Einstein by five years on the idea of Brownian Motion, he also had a well-developed idea on the pricing of stock options that pre-dated Black-Scholes by 70 years. Specifically, he defined the notion of put-call parity which is essential for modern options theory to work.

 

Nevertheless, Lo and Foerster have written a very helpful book for investors seeking sensible guidelines for retirement planning and who also would benefit from modern finance theory.

For the full amazon URL see: Thinking About Retirement Portfolios (amazon.com)

My Amazon Review of Richard Bookstaber's "The End of Theory: Financial Crises, the Failure of Economics and the Sweep of Human Interaction"

Stuff Happens

Richard Bookstaber a long time finance practitioner/risk manager who has worked for Morgan Stanley, Salomon Brothers, Moore Capital and Bridgewater as well as the Financial Stability Oversight Council and the Office of Financial Research has written a broad-based attack on financial economics and the DSGE models now used by most central banks. Trust me he knows what he is writing about and in the interests of full disclosure I interacted with him when I worked at Salomon Brothers.

Although not cited he is writing in the tradition of Nicholas Nassim Taleb (“The Black Swan”) with his fundamental disagreement with the theoretical underpinnings of financial economics. Simply put in a world of radical uncertainty we don’t know the underlying probability distributions of future financial returns and we don’t even know the potential states of the world needed to calculate a probability distribution. He argues that modern finance theory is built around top down axioms based on deductive reasoning where an all knowing representative individual calculates the future probabilities for all of the known states of the world. And importantly the future probability distribution is based on historical evidence. Under radical uncertainty that simply does not work.

Instead he argues for agent based models built upon inductive reasoning where the actors are “reflexive” in the word used by George Soros, in that they respond to the actions of others. As much as economists envy physics, Bookstaber turns the Heisenberg uncertainty principle on them. Thus while financial theory works in normal times, in a crisis all bets are off as “stuff happens.”

What Bookstaber would like is to use agent based models that are used to model automobile traffic and schools of fish, for example, through the use of complexity theory. All this is fine and good, but aside from a narrative Bookstaber does not offer up a formal model for the financial markets. Perhaps he has one, but it is not here. Nevertheless he offers a road map for future research.

At times Bookstaber’s writing style is clear and lucid with analogies from literature motion pictures and military combat. He is a student of “OODA”, observe, orient, decide and act. He is particularly acute in his discussion of the origins of the financial crisis and is highly critical of the role played by Goldman Sachs in their failure to honor a small “novation” request from Bear Stearns, which brought that firm down. However, at other times his writing is dull and staid

Bookstaber has written an important book and it should be read by risk managers and policy officials. The old models failed in 2008, now almost ten years later it is time for new ones.

The full Amazon URL appears at:
https://www.amazon.com/review/R14VHKPZ87FCAC/ref=pe_1098610_137716200_cm_rv_eml_rv0_rv