Investment advisers and managers are operating in accordance with a manual written half a century ago that no longer applies to the most important aspects of investment.
This doesn’t bother the regulators, who are always conservative and are more interested in the volume and consistency of rules than in their quality or relevance.
It doesn’t particularly interest the designers of professional examinations, who continue to make modern portfolio theory and its ugly mathematics the core of ‘knowledge’ in the subject despite their comprehensive discreditation over the past two decades.
As for advisers, most pride themselves on being ‘practical men’ who take theory with a pinch of salt and use sensible methods grounded in experience. Except that they don’t: instead of thinking, they mostly tend to enthusiastically adopt the latest fads peddled by product salesmen.
The most notable feature of financial markets over the past two decades has been a transformation of their purpose. In a world where minimal capital is required to launch an enterprise and most value is created by brains, not brawn, astute commentators have pointed out that equity markets serve not to raise capital – which is what the manual says – but to permit the founders of successful businesses to sell on their own terms.
The result is that public equity markets now raise such trivial amounts of money for investment that they might as well not exist: since they do not improve our standard of living by placing real capital to work in productive enterprises, they are not net contributors to collective wealth. As Keynes pointed out in the 1930s, the secondary market simply allows everyone to play the game of ‘Old Maid’ and pass the paper, a game which can be fun but which does not increase collective wealth.
Portfolio diversification was practised for 3,000 years before Markowitz and MPT’s mathematised version of diversification only delivers benefits if you believe risk is accurately measured by standard deviation. It isn’t. That was just a convenient simplifying assumption of the type that academics make all the time but that people who think of themselves as pragmatists should avoid like the plague. In investment, rules of thumb are better than MPT’s rules of dumb.
Outside the crumbling walls of the old paradigm, an investment revolution is beginning. The internet is facilitating real investment on the kind of risk-sharing basis that makes sense to individual investors who – luckily for them – have never read any MPT.
Crowdfunding for both debt and equity is on an exponiential growth trajectory. Almost all this finance is directed to real investment that will, if successful, increase our collective standard of living in a way that buying or selling Shell or Diageo will not.
Do investors care that the probable volatility of such investment is off the scale? No. And they’re right, because high-risk equity investment is pretty much binary (the moon or merde) and investors know this and usually combine it with piles of boring old cash.
Real investment, then, is on its way back, though currently below the radar. After another bear market in listed equities, who knows? But you have to be pretty dumb not to see that the rewards of investing in public markets go primarily to managers, employees and advisers rather than shareholders.
Unless the casino produces better payouts, sensible folk will find somewhere else to play.
Chris Gilchrist is director of Fiveways Financial Planning, a contributing author to Taxbriefs Advantage and edits The IRS Report