Something I find very interesting is the lack of rigor in most business fields. One would think that given the importance of business that we'd not be so loose with how we construct our ideas. The lack of rigor is pretty explicitly responsible for a large range of issues in the business world.
When I say rigor, I am very explicitly referring to the concept in the mathematical sense. When I say rigor, at least informally I am saying that the argument put forward needs to stand on its own without reference to any outside material. An easy way to conceptualize this is that the argument must make clear the assumptions being used and walk from those assumptions to what the conclusion is. To be clear, I am not talking about someone at some random company having to dot every i and cross every t like this in order to use an idea. I am explicitly talking about the ideas themselves, and how they the ideas themselves are interacted with as ideas.
I am going to focus my attention on finance/economics both because this is where my knowledge of theory is deepest and because it provides the clearest examples of what I am talking about. From undergraduates to PhDs and onwards, virtually all of the economic theory that gets taught follows the "standard" economic model (aka neoclassical economics or a derivative thereof). To be as charitable to standard economics, standard economics is a special case of a more general theory. We see this a lot given how so many recent advancements in economic theory have been from explicitly rejecting the underlying assumptions of standard economics. And this makes sense. Removing arbitrary restrictions on the theory will lead to the new ideas being more generally applicable. For example, when you assume rationality, you can't explain all the behaviors in the stock market. But when you don't assume rationality, you are able to explain all the behaviors in the stock market.
This is rather frustrating. First, if there was more rigor in such fields, the limitations of the theory would become more clear to more people and we could make further advancements sooner. Doing this would have significant positive impacts on the world. Second, the underlying standard theory is not being updated for the more general theory. We still primarily teach the special theory. This is why when you ask basically any economist about the assumptions they are using, whether their education stopped in undergrad or are PhDs, whether they are in school now or are senior economists, they won't be able to recognize that what they are using is "merely" a special theory.
And the thing is, we know there are more general theories. These have been developed (albeit are by no means complete). We don't have to stick to pretending that the special theories are generally the case. To compare this to physics, we know general relativity is real. Special relativity is not the only relativity that exits. Physicists use both.
I am hoping that this will lead to an interesting discussion. Unfortunately, knowing who uses WSO, the best I should hope for is that this just avoids turning into blood sports among people who demonstrate the validity of my views. Although if someone comes in here saying some version of "buT iT iS sTandArD foR a ReaSoN. iF thErE iS a BetTer TheOry, wHy iSn'T tHaT StaNDaRd," I will make fun of you by using the more general theory to demonstrate why exactly such a thing happens.
Thanks for coming to what is effectively a journaling exercise
The lack of rigor in business-related fields, particularly in finance and economics, is a recurring critique, and your observations align with some of the most insightful discussions on WSO. Here's a breakdown of the key points and their implications:
Standard Economic Models and Their Limitations:
The Need for Rigor in Theoretical Foundations:
Educational and Practical Implications:
Resistance to Change:
Your critique highlights the importance of fostering a culture of intellectual rigor and openness to new ideas in business-related fields. By challenging the status quo and advocating for more comprehensive theories, we can pave the way for meaningful advancements in finance and economics.
Sources: Why a lack of advanced modeling techniques? Anyone who uses probabilistic modeling justification for this?, What does an impending recession mean for students wishing to pursue a career in finance?, Is Traditional Finance Dead?, Do any of you feel like you've had an intellectual decline after starting college because of majoring in business?, 1st Year Macro HF Analyst: My Macro Framework
(1) "Ockham's razor."
Occam's razor actually has a pretty good explanation for this. It only really requires three words too. This is pretty much entirely explained by the lock-in effect. We choose significantly inferior economic models because of historical happenstance and the reality of positive feedback.
(2) "I would argue that good economists understand the assumptions and thus the model limitations, but make them useful."
Then there are very few good economists out there in the world. I broadly agree with this sentiment, just this is not what the overwhelming majority of economists do.
(3) "What is out there today that's better?"
Complexity Economics provides a more general theory of economics that is able to better predict what actually happens in the economy. It can explain equilibrium and non-equilibrium phenomena. For example, we can look at the COVID-related research Doyne Farmer's team did. Entirely prospectively, they tried to forecast the economic impact of the COVID shutdowns to England's economy. Their predictions were over 100% more accurate than the ones that relied upon standard economic theory.
I know what you mean bro imagine paying $100k for an MBA and they spend their time talking about porters 5 forces💀
who cares we're here to make money
This leads to more people making less money. If you care about making money, accurately understanding economics is kind of important.
Economics is simply just a blueprint but in no way is it a deep fundamental grasp actually necessary for most people
A practical person might just grab a tool and start using it, even if they're missing steps in-between, as long as they're directionally right that's all that really matters in my view
And then in investing, you have the passive crowd who are nearly completely inelastic in regards to market prices, fundamentals, macro, etc... who have done well
"Economics is simply just a blueprint but in no way is it a deep fundamental grasp actually necessary for most people A practical person might just grab a tool and start using it, even if they're missing steps in-between, as long as they're directionally right that's all that really matters in my view."
(1) This is very explicitly not commentary about "most people." This is about people who are engaging with economics. What you are suggesting is along the lines of particle physicists not needing to know the Standard Model in order to do particle physics.
(2) A practical person may just grab a tool and start using it. To keep with your analogy, this is also how decisions get made at the highest levels of the economy and across the most influential decision makers in the economy. There are countless examples in economics that we have that show the danger of this approach. You get completely wrong directionality if you don't actually capture the phenomena that are relevant.
For example, when the Treasury asked the Fed in around 2006 what would happen if the housing market crashed, the Fed gave fundamentally incorrect guidance to the Treasury that completely missed the reality of such a crash because of the Fed's reliance on standard economics (aka they used an equilibrium model to forecast a non-equilibrium phenomena). Let me say this again. The Treasury asked the Fed in about 2006 what would happen if the GFC were to happen. The Fed got the directionality completely wrong because they were using standard economics when standard economics is not able to capture the non-equilibrium phenomena that they were asked to analyze
A lot of business and econ stuff feels kinda hand-wavy compared to other fields. It’s weird how often big ideas are built on shaky assumptions that don’t always hold up in the real world. You’d think we’d update things more often, especially when better models exist.
The funny thing to me is that many of the good economists know this. They know that their economic framework is internally consistent but has very little to do with the real world. A really great example of this comes from Fama and his guidance to Scholes regarding LTCM. Even Fama was saying how Scholes shouldn't take the theory they spent so much of their lives developing too seriously.
Unfortunately, after the GFC Fama backtracked on this. I don't blame him since basically his entire life's work was shown to be nonsense. But it is still disappointing nonetheless.
The Fama-Scholes-LTCM moment is such a perfect example. It’s almost like Fama was saying, “Hey, don’t actually use this stuff to bet billions,” but then watched as it happened anyway
In my view, theories are useful for understanding the core, non-deviating drivers behind things. They give you the structure or framework around a topic. It’s a foundation you can shape to fit your specific situation or reality. But it should never be treated as a tool for direct analysis. Seriously heard people using Black-Scholes to decide if a derivative is under- or overpriced lmao
but anyway, a great example to undersatnd the importance of some generic theory is the MM theorem. It starts with a very simple idea of what drives a company’s value. Then you start adding real-world elements things like taxes, debt, and so on. At that point, you take everything you’ve built and apply it to a specific company to get an actual result.
What makes MM different from other theories, especially the ones about general market behavior, is that it gives you a framework you can actually use to analyze a single company. That analysis gives you values that most of us would agree represent the economic reality of that asset. So you take the core MM ideas and test them against something real, like the actual numbers in a model or valuation which are objective and have no room for deviations in terms of behavior; a number is just a number. What you can’t do, though, is apply MM’s assumptions to a whole bunch of companies all at once. Each one has to be looked at separately, and each gives you a different outcome.
That’s the opposite of what a lot of public market theories try to do. Those usually aim to simplify something very complex and turn it into one big explanation for how the market behaves. In a perfect world, sure, you could isolate every market participant, analyze their behavior and risk preferences, and then combine all of that into something that approximates how the market works. But here’s the problem. Time. You’d be using information collected at a specific moment and trying to apply it to a future reality that doesn’t exist yet. The market shifts. People change. Maybe when you asked me about a stock I was optimistic, but today I fell down the stairs and now I’m not in the mood to take risks. I’m more cautious. My behavior changed, just like that.
And then come all the theories that try to fix the flaws in the ones before them. Each one brings a new layer of generalization. Over time, we get to a point where generalizing doesn’t work anymore because there’s just too much variety and unpredictability which would make the formula complete. But finance theory still tries. It throws a number on it, averages it, calls it a value (50k potential paths? Sure, let's do a MC, draw the average and this will do). Then someone else comes along and refines it with a slightly better number (we shouldn't do the average but give a 65% weight based on the positive numbers because based on my regression this numbers proves that market is upward biased), and the cycle continues.
The bottom line is this. Theories in the stock market give us a useful framework. But lots of theories on public markets fail when there is a human element to it. The more objective and distanced from human behavior the theory is the more it holds (maths/physics/chemistry - all laws and rules still unchanged from centuries), but on finance/economics? You could find a paper talking about 57 B.C. Mesopotamia proving that tariffs grew the community hypothetical GDP with 23% YoY and you based on this you prove that tariffs are good. But again? Are 2 moments in time as comparable? I doubt it: Sociology/history/economics/culture/etc. play a huge role in those social sciences theories.
The theories are useful for quantifying risk/reward and then arbitrage discrepancies between those: What quants do.
Or trying to understand how the economy behaves/people think/will react, and take a decision based on this: What corporate finance/fundamental investors do.
something very objective stops being theory i.e., I see a company that is worth 100 if liquidated but it's sold for 89? That's not theory, that's a backed-up observation. Corporate Finance tries to reach this sort of objective reality, but is never 100%, and even less anything that has to do with public markets.
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