Changed Reality: Attack of the Financial Mathematicians

We have looked at what happened in the field of corporate strategy untll 1970 in my last post. Now let us take a quick look (in overly simplistic terms) at what happened in the field of Corporate Finance during the same period.

It could be argued that ‘modern finance’ started with a 1952 paper from 25-year old student named Harry Markowitz. Markowitz was the first to mathematically prove the concept of well-diversified portfolio and how it leads to maximum returns with the least possible risk. He sent a powerful message to the financial world, ‘risk is central to the whole process of investing’. Markowitz’s paper languished in academia until Tobin and, later, Sharpe made some fundamental improvements to the concept around 1960.

[Behind every disaster there is a thought that seemed perfectly normal. Certainly there was nothing wrong with Markowitz’s assertion that a combination of risky holdings can together make a low-risk portfolio as long as individual stocks do not move in tandem with each other. As years went by, the market really believed that it is possible to manage risks -- until a black swan event crashed all the stocks together in 2008.]

While these mathematicians were making significant improvements to the theory of risk-based investing, there was a group of statisticians who were pursuing a completely different path.

Working in 1934 and in 1953, Kendall came to some startling conclusions based on the stock market price change data. Roberts built upon the conclusions to publish “Stock Market ‘Patterns’ and Financial Analysis’ in 1959. What was the insight of these statisticians? They proved beyond doubt that the price changes in a stock market are completely random. What is amazing is that in 1959, completely unaware of these statisticians, M.F.M. Osborne published a research paper called “Brownian Motion in Stock Market” [Brownian motion is also known as random walk theory]. This was essentially the birth of algo-trading.

The work of Samuelson, Fama and Black deserves a mention as well. Leading up 1970 they formulated two important assertions

  1. Efficient Market Theory framework. This framework basically gave a justification for stock market values. If a stock is valued high then it must be worth a lot…since it is valued high.
  2. Fama and Black also provided a mathematical proof that in the long run it is not possible to beat the market.

It is not obvious but the direct conclusion of (1) and (2) above is that the only people who can beat the market are those who have access to information. (Rajratnam would eventually prove them wrong, the idiot managed to lose money even when he had inside information.)

The quest for access to information gave a significant boost to the role of professional money managers. These managers spent most of their time researching stocks = They had up to date and immediate information = They could beat the market. (Nice concept except that as time went by, most of the trades on Wall Street came from professional money managers.This meant every trader had information. This, in turn, motivated money managers to gather inside information or indulge in Madoff style imaginary trading to beat the market and justify their income.)

Last but not the least; the final nail in the coffin was delivered by, Modigliani and Miller around 1970. They provided mathematical proof for –

  1. Why it is better for the company to NOT to pay a dividend;
  2. Low debt is a sign of incompetent management as taking on debt increases the value of corporation;
  3. The amount of debt does NOT have negative impact on the valuation of a company.

Modigliani and Miller were awarded the Nobel Prize in economics for this and other contributions. It did not matter that common sense told us otherwise, i.e., to treat debt with extreme caution.

In the next post, let us understand how finance and strategy came together to drive down the nation’s wealth. It should be an eye opener for all the suckers who believe in ‘trickle-down-give-tax-breaks-to-rich’ theory.