Protesting is popular these days. Everyday there seems to be a new mob of people ranting against some form of injustice. Time Magazine was among the first to acknowledge this trend by making its 2011 Person of the Year a generic persona called “The Protester”. While protesters often target corrupt politicians, polluting corporations, even annoying young pop stars, the time has come to stand up against another group threatening to corrupt society with radical views: mathematicians. In addition to being an economist, I am a wealth advisor, which is a fancy way of saying I manage people’s money.
Millions of people around the world depend on wealth advisors to achieve their financial goals (i.e. retirement, sending a child to university, funding cancer research), so I regard my profession as a noble one. Although the birth date of my profession is uncertain (some historians argue it debuted in 1774 when a Dutch merchant created the first investment trust), modern wealth management started to blossom in the 1920s. Wealth management is a wonderful subset of finance because it combines the best of mathematics and economics. Stock markets are incredibly complex systems driven by logic and emotion, patterns and randomness. Professional wealth managers are uniquely equipped to handle this complexity, using mathematical tools to understand the logical parts, and economic tools to understand the parts that appear irrational.
By leveraging the best tools from both disciplines, wealth managers are able to understand and navigate the vast complexities of investing. The early academics in finance contributed greatly to our understanding of investing. Concepts like the trade-off between risk and return, the differences between asset classes, and the benefits of diversification have forever improved the way we manage our scarce financial resources. However, somewhere along the line the profession got off track. The mathematicians began to muscle out the economists. It’s easy to understand why math stole the spotlight. Mathematics uses equations resulting in neat logical answers. By contrast, economics is a social science that often deals with messy human stuff like greed, fear, virtue and vice. After a golden period of relative balance between math and economics, wealth management professionals increasingly turned to math purists to answer the financial problems of the day. Any human behaviors that could not be explained using a formula were dismissed as anomalies, instead of being addressed using tools from other disciplines. It appeared to work well for a while. Math seemed to explain just about everything in the financial world.
Complex algorithms were created to trade stocks at the speed of light. Giant hedge funds combined computing power and huge amounts of leverage to create incredible profits. But then the cracks began to appear. In 1998, the trading strategies at Long-Term Capital Management (a hedge fund) exploded so spectacularly that the U.S. Federal Reserve had to step in to clean up the mess.
Ten years later the 2008 financial crisis hit, which pushed the world economy to near collapse. Many blame the 2008 crisis on the perverse financial engineering prevalent at the time. In the end, math was not able to stand on its own. Luckily, the pendulum is starting to swing back to a more balanced state. The industry is again incorporating human behavior into its processes. An economic field called behavioral finance is taking on messy human emotions head on, giving wealth managers better tools to deal with these issues. For example, holding a low yielding GIC is no longer viewed as an irrational anomaly; the foregone extra return is now seen as the price an investor pays to sleep well at night.
Similarly, a new approach called “goalsbased wealth management” has produced investment plans that are “behaviorally optimized” to account for the real impacts of human reaction. By contrast, mathematically optimized investment plans only look at returns, so the emotional burden of things like extreme volatility are the investor’s problem. A favorite quote comes from John Maynard Keynes: “It is better to be roughly right than precisely wrong.” The wealth management industry would do well to remember that investors are humans that cannot be defined using a magical formula. Like many things in finance, a balanced approach is best.
By: Paul Carvalho
Paul Carvalho MA CFA is President, Chief Economist and Wealth Advisor with Reeves Private Wealth. He has spent 15 years in finance with a global custodian bank, a major investment firm and a Canadian Chartered Bank.