Anyone Can Become President

Anyone Can Become President

And now a brief history of the “Nobel” Prize in economics, which was established by the Bank of Sweden in honor of Alfred Nobel, who may be, according to his family who wants the prize abolished, now rolling in his grave with disgust. An activist family member calls the prize a public relations coup by economists aiming to put their field on a higher footing than it deserves. True, the prize has gone to some valuable thinkers, such as the empirical psychologist Daniel Kahneman and the thinking economist Friedrich Hayek. But the committee has gotten into the habit of handing out Nobel Prizes to those who “bring rigor” to the process with pseudoscience and phony mathematics. After the stock market crash, they rewarded two theoreticians, Harry Markowitz and William Sharpe, who built beautifully Platonic models on a Gaussian base, contributing to what is called Modern Portfolio Theory. Simply, if you remove their Gaussian assumptions and treat prices as scalable, you are left with hot air. The Nobel Committee could have tested the Sharpe and Markowitz models—they work like quack remedies sold on the Internet—but nobody in Stockholm seems to have thought of it. Nor did the committee come to us practitioners to ask us our opinions; instead it relied on an academic vetting process that, in some disciplines, can be corrupt all the way to the marrow. After that award I made a prediction: “In a world in which these two get the Nobel, anything can happen. Anyone can become president.”

So the Bank of Sweden and the Nobel Academy are largely responsible for giving credence to the use of the Gaussian Modern Portfolio Theory as institutions have found it a great cover-your-behind approach. Software vendors have sold “Nobel crowned” methods for millions of dollars. How could you go wrong using it? Oddly enough, everyone in the business world initially knew that the idea was a fraud, but people get used to such methods. Alan Greenspan, then chairman of the Federal Reserve bank, supposedly blurted out, “I’d rather have the opinion of a trader than a mathematician.” Meanwhile, the Modern Portfolio Theory started spreading. I will repeat the following until I am hoarse: it is contagion that determines the fate of a theory in social science, not its validity.

I only realized later that Gaussian-trained finance professors were taking over business schools, and therefore MBA programs, and producing close to a hundred thousand students a year in the United States alone, all brainwashed by a phony portfolio theory. No empirical observation could halt the epidemic. It seemed better to teach students a theory based on the Gaussian than to teach them no theory at all. It looked more “scientific” than giving them what Robert C. Merton (the son of the sociologist Robert K. Merton) called the “anecdote.” Merton wrote that before portfolio theory, finance was “a collection of anecdotes, rules of thumb, and manipulation of accounting data.” Portfolio theory allowed “the subsequent evolution from this conceptual potpourri to a rigorous economic theory.” For a sense of the degree of intellectual seriousness involved, and to compare neoclassical economics to a more honest science, consider this statement from the nineteenth-century father of modern medicine, Claude Bernard: “Facts for now, but with scientific aspirations for later.” You should send economists to medical school.

So the Gaussian * pervaded our business and scientific cultures, and terms such as sigma, variance, standard deviation, correlation, R square, and the eponymous Sharpe ratio, frequently used in Gaussian models, pervaded the lingo. These quantities do not themselves require a Gaussian distribution, though their interpretation and reliability depend on the assumptions and data. If you read a mutual fund prospectus, or a description of a hedge fund’s exposure, odds are that it will supply you, among other information, with some quantitative summary claiming to measure “risk.” That measure will be based on one of the above buzzwords derived from the bell curve and its kin. At the time of this account, for instance, pension funds’ investment policy and choice of funds are vetted by “consultants” who rely on portfolio theory. If there is a problem, they can claim that they relied on standard scientific method.