Episode 73
Quantifying Uncertainty: A History of Financial Theory and its Implications | Daniel Peris
Episode 73
Daniel Peris
Quantifying Uncertainty: A History of Financial Theory and its Implications | Daniel Peris
summary
In this week’s episode of Hidden Forces, Demetri Kofinas speaks with Daniel Peris, a Senior Portfolio Manager at Federated Investors in Pittsburgh where he oversees the firm’s dividend-focused products. He is the author of three books on investing, most recently: “Getting Back to Business: Why Modern Portfolio Theory Fails Investors, and How You Can Bring Common Sense to Your Portfolio.” Before transitioning into asset management, Peris was a historian focused on modern Russian history. He is the author of a book and several articles on the Soviet Union in the 1920s and 1930s.
Today’s conversation is about the evolution of financial theory, beginning with the rough and tumble world of 19th-century finance with its stock syndicates, market corners, and curb exchanges. Where big personalities like Daniel Drew, James Fisk, and Jay Gould conspired and fought to take from Joe Public, and from each other, the riches afforded to them by laissez-faire capitalism and the industrial revolution.
The discussion is broken into two parts. The first deals with the world as it was before 1929 with its unregulated, unstructured, and highly inefficient markets. The second part explores the world after the Great Crash, where a confluence of forces – economic, demographic, institutional, and intellectual – supported the procurement and distribution of a new set of financial theories that promised to explain away uncertainty and guide the allocation of risk in the pursuit of profits.
As inheritors of this new world, we cannot help but function under the fallacies of its paradigms. One of these fallacies is the notion that economies are independent phenomena that operate, by and large, according to a certain set of physical laws. Most people will acknowledge that our economic and financial models are imperfect, but most people also think of them as being somewhat analogous to models developed in the natural sciences. Because of this false comparison to physics (equilibrium) and nature (normal distributions), people often remain unaware of the centrality of politics in theories of the economy. Economies are not independent phenomena that answer only to the laws of nature. They are political and social phenomena that exist within a political system. Theories of the economy that do not take into account the system within which they operate are flawed…in some cases, significantly so.
Austrian theories of money and credit, for example, are better at describing how the banking system operates in a laissez-faire society, whereas Modern Monetary Theory is better at describing how it works in our current, fiat-based system of unrestrained credit growth. What often happens is that devotees of these different schools are actually advocating for a specific set of policies, under the pretense that their views are scientific and that their policies derive logically from some objective view of how an ideal economy operates, when in fact, they are based on political values and societal ideals. The MMT school is full of progressive social-democrats who want governments to play a larger role in the economy, whereas the Austrian school is full of conservative libertarians who want less government. This sorting along political lines is not a coincidence. Investment theories operate rather differently than theories about the economy, in that there is no argument in the investment world about what matters most. It’s profits.
In light of this fact, the discrepancies between various investment theories require alternative explanations that do not rely on political ideology or moral sentiment. It would seem sufficient to declare that the widespread adoption of theories like Modern Portfolio Theory (MPT), the Efficient Market Hypothesis (EMH), Capital Asset Pricing Model (CAPM), etc., was enabled by the growth of a large middle class with excess income available for investment that had not directly experienced the boom and bust of the Roaring 20’s and accelerated by the Employee Retirement Income Security Act (ERISA) of 1974. Entrepreneurially minded financial industry professionals saw an opportunity, but this opportunity required a more streamlined approach to investing and one that would put themselves, and their clients, at ease.
The need to bring order to the chaotic world of prices has encouraged the adoptions of systematic investment strategies that claimed the ability to quantify risk. When it comes to investing other people’s money, having a more coherent, easy-to-understand theory that provides the illusion of control is a very valuable tool. From an evolutionary point of view, it is no wonder how theories purporting to quantify risk and target reward proliferated so quickly. It was in everyone’s interest that they do so.
How these theories came together to form the dominant, ideological template of risk-adjusted-return measured against exposure to the broader market is the essence of today’s episode. Its significance can be found in the implications associated with equating diversification with correlation: trading idiosyncratic risk for systemic risk and what happens when everyone is doing it.
Producer & Host: Demetri Kofinas
Editor & Engineer: Stylianos Nicolaou
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bio
Daniel Peris, Ph.D., CFA, is Senior Vice President and Senior Portfolio Manager at Federated Investors, Inc., in Pittsburgh. Before transitioning into asset management, Peris was a historian focused on modern Russian history. He is the author of two prior books on investing, The Strategic Dividend Investor, and The Dividend Imperative, as well as a study of early Soviet history.
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Perge porro; Quam tu ponis in verbis, ego positam in re putabam. Non est enim vitium in oratione solum, sed etiam in moribus. Ergo in gubernando nihil, in officio plurimum interest, quo in genere peccetur. Utrum igitur percurri omnem Epicuri disciplinam placet an de una voluptate quaeri, de qua omne certamen est? Re mihi non aeque satisfacit, et quidem locis pluribus. Quem Tiberina descensio festo illo die tanto gaudio affecit, quanto L. Tu vero, inquam, ducas licet, si sequetur;
Etsi ea quidem, quae adhuc dixisti, quamvis ad aetatem recte isto modo dicerentur. At modo dixeras nihil in istis rebus esse, quod interesset. His similes sunt omnes, qui virtuti student levantur vitiis, levantur erroribus, nisi forte censes Ti. Quae in controversiam veniunt, de iis, si placet, disseramus. Ut ad minora veniam, mathematici, poëtae, musici, medici denique ex hac tamquam omnium artificum officina profecti sunt. Quodsi vultum tibi, si incessum fingeres, quo gravior viderere, non esses tui similis;
Nam his libris eum malo quam reliquo ornatu villae delectari. Atque hoc loco similitudines eas, quibus illi uti solent, dissimillimas proferebas. Praeclare enim Plato: Beatum, cui etiam in senectute contigerit, ut sapientiam verasque opiniones assequi possit. Possumusne ergo in vita summum bonum dicere, cum id ne in cena quidem posse videamur? Ut enim consuetudo loquitur, id solum dicitur honestum, quod est populari fama gloriosum. Si id dicis, vicimus. Falli igitur possumus.
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At eum nihili facit; Cum id fugiunt, re eadem defendunt, quae Peripatetici, verba. Sed quid attinet de rebus tam apertis plura requirere? Cui Tubuli nomen odio non est? Licet hic rursus ea commemores, quae optimis verbis ab Epicuro de laude amicitiae dicta sunt.
Quamvis enim depravatae non sint, pravae tamen esse possunt. Quae in controversiam veniunt, de iis, si placet, disseramus. Nec vero pietas adversus deos nec quanta iis gratia debeatur sine explicatione naturae intellegi potest. Hoc mihi cum tuo fratre convenit. Cupit enim dícere nihil posse ad beatam vitam deesse sapienti. Quaesita enim virtus est, non quae relinqueret naturam, sed quae tueretur. Roges enim Aristonem, bonane ei videantur haec: vacuitas doloris, divitiae, valitudo;
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Huius, Lyco, oratione locuples, rebus ipsis ielunior. Hic quoque suus est de summoque bono dissentiens dici vere Peripateticus non potest. Quis enim est, qui non videat haec esse in natura rerum tria? Mihi enim satis est, ipsis non satis. Quam illa ardentis amores excitaret sui! Cur tandem? Ita multa dicunt, quae vix intellegam. Sic consequentibus vestris sublatis prima tolluntur. Deinde disputat, quod cuiusque generis animantium statui deceat extremum.
Est igitur officium eius generis, quod nec in bonis ponatur nec in contrariis. Ex quo, id quod omnes expetunt, beate vivendi ratio inveniri et comparari potest. Quamquam ab iis philosophiam et omnes ingenuas disciplinas habemus; Si verbum sequimur, primum longius verbum praepositum quam bonum. Nunc omni virtuti vitium contrario nomine opponitur. Atque his de rebus et splendida est eorum et illustris oratio. Quod ea non occurrentia fingunt, vincunt Aristonem; Qua tu etiam inprudens utebare non numquam. Non autem hoc: igitur ne illud quidem.
Materiam vero rerum et copiam apud hos exilem, apud illos uberrimam reperiemus. Dicam, inquam, et quidem discendi causa magis, quam quo te aut Epicurum reprehensum velim. Tu autem negas fortem esse quemquam posse, qui dolorem malum putet.
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Qualem igitur hominem natura inchoavit? Ergo instituto veterum, quo etiam Stoici utuntur, hinc capiamus exordium. Sed ad haec, nisi molestum est, habeo quae velim. Nummus in Croesi divitiis obscuratur, pars est tamen divitiarum. Mihi vero, inquit, placet agi subtilius et, ut ipse dixisti, pressius. Sin tantum modo ad indicia veteris memoriae cognoscenda, curiosorum. Quicquid porro animo cernimus, id omne oritur a sensibus;
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