James Montier delivered the keynote speech at this year’s annual conference of the CFA Institute.  It was titled simply, “The Flaws of Finance.”  Just as simply, Montier’s job title was given as “investment professional.”  His informative and entertaining talk (which is available onlineCFA Institute | Montier’s remarks appear about eighteen minutes in.) was a perfect prelude to presentations about the topics of the day, many of which reflected three colliding elements — the investment profession, the business, and theories of finance.

To summarize my impressions of the conference I will be doing a series of postings, on this site and on research puzzle pix, where the first dispatch appeared.the research puzzle | This link will provide an updated list of the entire series as it proceeds.

Montier’s talk was structured around four flaws:  Bad models, bad policies, bad incentives, and bad behavior.  Taken together, they have proven to be a toxic mix for the modern financial system, investment decision makers, and all who have had to pay to clean up the mess.

While models are alluring, “finance does not equal physics” and “market participants are not inert,” but active.  Finance is a social science and the simplifying assumptions of many models render them helpful in only a theoretical way, since they repeatedly fail the test of reality.  The capital asset pricing model (CAPM) and value-at-risk (VaR), each widely used, might provide interesting food for thought, but their underlying assumptions render them not only fallible but dangerous in practice.

Unlike CAPM’s definition, Montier says that “volatility isn’t risk.”  Ultimately, he believes, risk is the permanent impairment of capital, but the analysis of risk is multifaceted and can’t be summarized by a statistic.  Plus, ignoring illiquidity and leverage, as CAPM does, “is just silly.”

Similarly, it’s hard to justify the tenets of VaR, which led to the errors of the financial crisis, since the model cuts off “the very part of the distribution that we need to worry about.”  Using trailing volatility and correlation results in a virtuous circle that works until it doesn’t, when its evil cousin (the vicious circle) comes into play.  And since everyone is using the same models, an institutional risk can become a systematic one.

That’s especially true since policy makers were convinced of VaR’s worth by the very banks that created it.  Montier called that “the world’s best example of regulatory capture.”

To make matters worse, layered on top are the bad incentives that permeate our financial system (which I wrote about in an eight-part series in early 2009the research puzzle | Frankly, not much has changed since then.) and the well-documented behavioral errors that distort investment decision making.  It is those errors that Montier thinks prevent us from seeing so-called “black swans” as the “predictable surprises” that most of them are, built upon a foundation of popularity, expensive valuation, leverage, and illiquidity.

Montier had a long list of suggestions for theorists, practitioners, and policy makers.  Many of them had to do with attitudes toward models, including a renewed sense of skepticism about what they actually can do.  Importantly, we must abandon our unattainable “obsession with optimality” that blinds us to the failures of models and theories.  But that is difficult for us, for just as we become impressed with the elegance of models, so too do our clients.  As a result, “we have a habit of liking complexity, because complexity impresses.  It allows people to charge high fees.  It keeps outsiders out.”  We “rely on complexity to baffle and bamboozle” when what our clients really need is to understand the uncertainty and murkiness of the markets.

As to the belief “that markets would do the right thing [to correct excesses] — we know that’s not the case.”  We have witnessed a failure of theory and practice, as well as a blindness to financial history and the triumph of expediency over ethics.

In related news, four days after Montier’s speech, J.P. Morgan announced its trading loss.  Point by point, you can add the specifics as annotations to a story that is already writ large.  If investment professionals won’t work to correct the flaws of finance, who will?