Saturday, May 19th, 2012
dance of the heavyweights

There were a lot of big names on stage during the CFA annual conference.  Arguably the two “biggest” did not make their names as practitioners, but as academics.  One is a professor of psychology and public affairs at Princeton, the winner of the Nobel Prize in economics despite never having taken an economics course.  The other is a professor of finance at the University of Chicago, who is often described as “the father of the efficient markets hypothesis.”

Daniel Kahneman and Eugene Fama appeared a day apart at the conference and were obviously worlds apart in their theories of economic decision making.  Fama is the dean of rationality and empiricism, while Kahneman sees the economic world in a behavioral context.  Both were entertaining and obviously brilliant.  One was left wondering what would have happened had they gone mano a mano.

As it was, the contrasting ideas of the two men were the backdrop for many of the conference sessions, even the ones that occurred before their presentations.  But it wasn’t just a battle of those two heavyweights that set the tone for the conference — it was their dances in turn with a third, the investment management industry itself.

One long-standing debate is that of active versus passive investment strategies, and Fama wasted no time in proclaiming the futility of active management in front of a sea of active managers.  Many that were in attendance manage growth stocks, but Fama told them that there’s a negative premium for growth:  “If you like growth companies, you take a lower expected return.”  He also questioned other popular industry ideas, saying that the current fascination with low-volatility strategies is actually based upon decades-old knowledge and when asked about risk parity asset allocation, he said he’d never heard of it, but that the concept sounded “stupid.”

Fama commented that “it’s hard to think of anything more valuable than having someone get you to think differently” and “you don’t know what’s going to surprise you next year or even next week,” yet most of his answers (during the session and in his publications) make finance sound like settled science.  When it comes to behavioral finance, he thinks that it is very good at the micro level but that it offers no insight to aggregate economic activity.

In contrast to Fama, who sees an overarching theory of finance, Kahneman comes at things from the ground up.  Much of his talk related to concepts explained in depth in his book, Thinking, Fast and Slow, which is about how we make decisions.  For practitioners, Kahneman’s talk was full of useful information, including the importance (and risks of) storytelling in decision making, our willingness to ignore key information if it suits us, and the overconfidence that seems to never go away, despite ample evidence that it should.  Those findings (and others) from Kahneman have direct impact for people who work in investment organizations and who deal with clients.

By definition, active managers think that they can beat the odds and outperform over time.  If so, Kahneman’s work should provoke more than a “gee, that’s interesting” response — it should aid the drawing of the blueprint for a successful investment firm.tjb research | If you don’t require your consultant to be a Nobel laureate, I can help you craft that blueprint.  His potential impact on the industry is significant, but given how hard it is to change the culture and processes of a firm, I think that change will be a long time coming.

Listening to Fama and Kahneman, I thought of a useful exercise for investment managers:  Try to explain your strategy in reference to Fama’s view of the world and your decision process in light of Kahneman’s observations of human behavior.  If you can do that, you are a giant step on the way to defining the set of beliefs that you embrace, the nature of the choices you will make, and the likelihood that you’ll be able to add value for your clients.

As disparate as the two men are, like all good thinkers they provide reference points by which you can determine where you are.

This is the fourth in a series of postings about the 2012 CFA annual conference.the research puzzle | This PDF is updated as new postings are created.