The Economist asks: “Fifty years after the dawn of empirical financial economics, is anyone the wiser?”
My short answer: “Only the people who understand both the data and its limitations, and not get lost in the illusion of precision.”
Markets are driven by myriad factors, most of which are readily quantifiable. But the small number of inputs that do not lend themselves to easy modeling is how certain empiricists get themselves into trouble. They believe their models accurately account for the real world, when they do not.
One would imagine that the parade of Black Swan events that keep upending their models would convince these economists otherwise, but you would be surprised at how foolishly stubborn these folks are.
The EMH proponents, the VAR analysts, the “stocks for the long run” folks — the grim reality of their performance has not dissuaded them from their beliefs. This has Yale Professor Robert Shiller concerned:
“[Shiller] worries that academic departments are “creating idiot savants, who get a sense of authority from work that contains lots of data”. To have seen the financial crisis coming, he argues, it would have been better to “go back to old-fashioned readings of history, studying institutions and laws. We should have talked to grandpa.”
Shiller puts his finger on the right pressure point. The factors ignored by the quants were the underlying changes in laws and regulations. That allowed banks to run wild, something the pure quants were not prepared to detect and act upon. The radical deregulation of the past 3 decades was the equivalent of dark matter, undetectable by Newtonian physics — or quant trading funds.
Shiller describes many modern economists and market observers as idiot-savants; truth be told, when using that phrase he is only half right.
Here is the Economist:
IT ALL began with a phone call, from a banker at Merrill Lynch who wanted to know how investors in shares had performed relative to investors in other assets. I don’t know, but if you gave me $50,000 I could find out, replied Jim Lorie, a dean at the University of Chicago’s business school, in so many words. The banker, Louis Engel, soon agreed to stump up the cash, and more. The result, in 1960, was the launch of the university’s Centre for Research in Security Prices. Half a century later CRSP (pronounced “crisp”) data are everywhere. They provide the foundation of at least one-third of all empirical research in finance over the past 40 years, according to a presentation at a symposium held this month. They probably influenced much of the rest. Whether that is an entirely good thing has become a matter of debate among economists since the financial crisis.
It is an interesting article worth perusing . . .
Economist Nov 18th 2010