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Incorporating the Experience of the Financial Crisis

Posted in Big Ideas, Investing Expertise

How should financial education incorporate the experience of the 2007-2009 financial crisis? In their May 2014 publication entitled Investment Management: A Science to Teach or an Art fo Learn?, Frank Fabozzi, Sergio Focardi and Caroline Jonas summarize the current approach to teaching finance theory and examine post-crisis criticisms and defenses of this approach via review of textbooks and studies and through interviews with finance professors, asset managers and other market players. Based on these sources, they conclude that:

  • Despite vague terms, unrealistic assumptions and empirical failures, current teaching mostly addresses mainstream neoclassical theories (based on bounded rationality, the Efficient Market Hypothesis [EMH], rational expectations and crash risk as external to the system).
  • The financial crisis emphasizes shortcomings of neoclassical theories, as follows:
    • The benefits of diversification change with the market environment.
    • Poor forecasting ability renders portfolio optimization of little use.
    • In practice, the Capital Asset Pricing Model (CAPM) is just a primitive approximation.
    • The rationality assumption of EMH is incompatible with large market swings.
  • While neoclassical theories are likely to continue dominating finance education, there is some rebalancing toward opposing beliefs that teaching should:
    • Acknowledge that extant theories of financial markets are weak.
    • Accept that CAPM is wrong and address it only for historical context.
    • Acknowledge that pricing via (unpredictable) discounted future cash flows is scientifically weak.
    • Address EMH critically with evidence of anomalies, or replace it entirely with the study of market predictability.
    • Incorporate fat tails, financial system instabilities and geopolitical risk into risk analysis.
    • Address crises as potentially generated somewhat predictably within financial systems rather than caused by external events.
  • Elements deficient in, or largely missing from, finance curricula include:
    • The importance of qualitative reasoning versus quantitative prediction.
    • Economics as a social system rather than a body of natural laws.
    • The history of financial markets for context regarding irrational exuberance.
    • Intuitive input to statistical modeling.
    • Risk management with non-normal return distributions.
  • Investment firms want managers with both mathematical skill and the ability to think critically based on broad knowledge, including a good sense of the possible and the impossible.

In summary, the 2007-2009 financial crisis appears to be nudging generally accepted finance education principles away from mainstream neoclassical theories.

Cautions regarding conclusions include:

  • Surveyed experts may not represent all important points of view.
  • The trend in beliefs may over-emphasize recent history.
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