Finance Theories - Practical? Useless?
Hello all,
I have just started taking finance courses at university that delve deeper into portfolio management theories and other finance topics. My question is; are these theories actually practical? Are they ever used in real-life or are they just theories that don't actually work in reality?
I actually tried to look for theories and see what could be applied to my real-life investments, but I could not see a connection and worried that I was just not understanding the concepts. I asked my professor about what these theories are used for, and he straight up told me that they have no use in real-life and not even professional investors use them. So why exactly are we learning this stuff? Is it useful in any way? Should I just not question what I'm learning and just focus on knowing the material for exams? Or is there something I'm missing here?
Thank you for your time, and I would really appreciate hearing what other peoples' thoughts about this.
gogo7
First thing's first - it wont help you squat in your investments. Financial theory aims at understanding how investors act and how the markets act (markets being an aggregate of investor decisions). It's not aiming at finding dominant trading strategies.
I don't know what your course looks like, but my lecturer was a pure genius and I absolutely loved portfolio theory and capm classes. As to real life applications, I think they're quite limited - theories just ram into your head two important messages: diversification helps and investors will not get compensated for taking on diversifiable risk. Thats it basically:) But still I find the knowledge extremely helpful. I know from experience that most people explaining WACC don't really know what they're talking about, they don't know the set of assumptions behind the model and can't infer how changing this set would impact the outcome.
But then again, Ive also seen some pretty boring ways to conduct classes on MPT and CAPM. If that is the case for you, I wouldnt pay too much attention...
If theory is correct then any deviation from theory is an arbitrage opportunity for you.
theory just provide a good starting point from which you base assumptions off, a good reference point to compare reality. No one, even the academics themselves, expect these to hold in real life.
E.g., a book about hedge fund managers, discussing how each of them generated alpha despite the EMH saying successful stock-picking is impossible. You see that having a solid theory as a reference point makes analysis much easier, as u compare real life to that starting point
I recommend to gain as much from the course as you can. Don’t ask “what does this do for me” but rather try to poke holes in it during class and ask lots of questions to gain a better grasp of some of the building blocks of finance.
If you want to gain actual investing knowledge - after that course I recommend taking it further and registering for equity valuation and risk modeling courses. The equity valuation courses are generally working as an ER analyst for a student run fund and will teach you how to dissect all parts of a company. Then the risk modeling portion will give you all the math skills needed to build a balanced portfolio and mitigate volatility risk. I found my risk courses to be incredibly difficult even though I love statistics, but the way those courses taught me to approach problems has proven to be some of the most beneficial skills I gained to date. Hope this helps
Of course financial theories make sense if you understand the basic concepts that explain them. It is not like a fucking bunch of illiterate morons created these theories. CAPM says taking greater systematic risk leads to higher returns. A similar statement can be made about the efficient frontier. In fact, they both suggest that taking more risk leads to higher returns. Understanding that the main way to get higher returns is to take higher risk is a practical concept.
The most important theory today is EMH, which eventually implies that trying to pick stocks that will beat the market is mostly a waste of time. The active mutual fund industry consistently proves this concept to be true. John Bogle created the Vanguard funds based on this concept and the ETF industry has been booming for decades largely based on EMH. We know the hedge funds and private equity people will say the opposite is true but they will not show you any data that prove their point. When you do not have any publicly vetted data, you can say your are wrong?
Cliff Asness was the TA for Eugene Fama, one of the big proponents of market efficiency. Cliff run a billion dollar hedge fund under the premise that markets are not efficient.
If modern portfolio theory were true, then yes, we all ought to buy VTI (RIP Bogle) and work in something else. Thing is, MPT is not always true and market values differ from intrinsic values frequent enough where certain gunslingers can pick up some alpha.
Some portfolio managers are complacent finding ways to remain near the benchmark in order to collect the 1% AM fee. See the book “Where are all the customers yachts?”
Financial theories are basically in their infancy. MPT was explored in the 1950s. Modigliani and Miller explored capital structure and leverage around the same time. Black Scholes was explored in the 70s. A lot has changed in the last 50-70 years. If this interests you, do a PHD and get paid to find the tracking error among index ETFs to Mutual Funds and underlying assets.
MPT is much more about structuring portfolios in terms of risk and returns and much less about fundamental analysis, which is a mostly different topic. Sure you can find stocks that beat the market but this exercise has proven to be a difficult thing to do. To some extent you are right about buying ETFs and calling it a day. This is what Benjamin Graham thought at the end of his career
Some portfolio managers are complacent finding ways to remain near the benchmark in order to collect the 1% AM fee. See the book "Where are all the customers yachts?"
That is true but that is because the historical efforts to deviate from benchmarks has not resulted in alpha for the majority of managers. If you are not going to beat the index, you might as well be close to it and get paid a nice fee.
pour one out for a real one
TLDR - people use models, they shouldn't use models, but you should understand them because investing is all about human behavior
models are weapons of mass destruction in the financial services industry when applied incorrectly. it's what got us CDS blowups, LTCM, and what I believe is at the heart of the LDI pension crisis in UK as well as FTX's meltdown (apart from it being an out and out ponzi)
I'm at a BB and I see where investment dollars go, many people actually do use MPT as a basis for asset allocation so your prof is wrong on there, but that doesn't necessarily mean it's a good thing. here's why
ok now that you're sufficiently cynical, why do you need to learn it? because 99% of investing success that's not due to dumb luck (and a lot of it is luck) is due to understanding human behavior. if you understand why other investors behave in a certain way (because they follow these models) you can potentially profit from it or avoid unforced rookie errors. I would learn the material and pass the class, but also understand that its implications will likely be stretching the truth
recommended reading
always thought most important thing & mastering market cycle was a whole doss of repetitive fluff that reiterates his memos. Book reviews reiterate this. Could just be an extended memo. Kinda disappointing how he's educated so many thru his memos but failed to deliver in his books which he constantly markets lol
well yeah, he admits the most important thing is just a collection of memos, but what is someone more likely to read, a handpicked collection of his favorite memos or going through all of his memos individually? also if his memos are good and the books are a collection of memos, wouldn't that make the books good?
next time I'll say "just read all of howard marks' memos instead of spending <$15 on a good book"
thanks for nitpicking though!
1) CALPERS is a definition of disaster. Same for Illinois's plan. All built off of blind following of generic models told by wholesalers who bugger off and don't care since "they got their's". Not to mention massive misallocation of funding issues, but that's a different topic.
2) See my comment about wholesalers above. On top of that, these models are created by academics that literally don't have any skin in the game and just literally punch it out in R or Python, etc and claim they have the "right numbers". They totally ignore the human factor. Because at the end of it, I can decide to just derail your supposed plan 'just because.' AKA the Joker in The Dark Knight, or what Elon did with TWTR for example. I'd bet dollars to donuts you could beat those academics straight up in a poker gsme or a game of Monopoly.
3) Backtests are great at seeing what did happen, but won't be able to give you any clarity on what will happen. Brofessor nailed it about human behavior being the true root. As they say, history doesn't always repeat, but it does at least rhyme more often than not. And that's the best a backtest is good for.
For reading, I'd also recommend Schwager's books. Market Wizards is great for instance because it's very conversational vs trying to preach some mathematic models or such.
Here's what I've learned after 15 years in finance:
People who rely only on theory and not practical experience are idiots.
People who make fun out of theory and academics are idiots.
Exist somewhere between these two points.
Atque quae repudiandae doloremque inventore quo. Officia ducimus amet inventore vero. Vel facilis voluptate distinctio. Est qui consectetur explicabo sint est. Repellat quae exercitationem temporibus inventore sed porro ut.
Repellat provident voluptas voluptatem et. Tenetur ea sit dolor id eveniet voluptates dolores adipisci. Nulla sed incidunt ex architecto labore est perspiciatis. Saepe quo voluptatem omnis excepturi qui. Tempore distinctio ut consequuntur ipsum.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...