Thursday, July 28, 2011

CAPM Interlude - The Theory of Theory

A theory’s purpose and objective is something I happened to learn in the psychology field rather than business.

The Two Objectives of a Theory
A theory needs to be:
a)      simple enough to be tractable yet
b)      robust enough to explain a lot of things.
If it accomplishes these two things it is “elegant”.
The theory’s power is its explanatory ability. It does not have to be real. For instance, while Freud’s theory involves an Id, an Ego and a Superego, these things do not actually exist in real life. They are created so that we can conceptualize these entities and intervene appropriately as the theory dictates.

On To Finance
A lot of economic and financial theories are criticized because they do not work in real life. However, as discussed above, that is not the purpose of the theory. It is to explain.
And the financial theories do this. Diversification reduces risk. There is a tradeoff between risk and return. Whether the beta of a stock is a good measure or not is quibbling about the details. There is a risk vs. return tradeoff, and it generally holds, in enough situations.

Diversification mitigates extreme portfolio swings, on average, in enough situations.
We asked why auction rate securities yielded more than variable rate demand notes in 2003. “There is a risk of failed auctions, in which case the investor would need to hold the security and would not get their funds back. But there hasn’t been a failure in over a decade”
Theory leads us to conclude “Fine, it hasn’t happened, but the risk is there”. It is up to each of us to determine whether that 10 basis points of return is worth it.

Those investing in auction rate securities in 2008 got to experience the actual reprucussions of that "theoretical" risk.

Key Takeaway
Learn the principles the theories teach us so we don’t have to learn them the hard way, but don’t believe reality can be made out of them either.

·         How has learning a theory improved your perception?
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  1. On the subject of theories, it is worth remembering what the great mathematician and physicist, Henri Poincare, had to say on the subject:

    "these two propositions 'the earth turns round', and 'it is more convenient to suppose that the earth turns round', have one and the same meaning"

    (p 91 in The Value of Science, )

  2. Tim,

    Thanks for the comments, I always love a good quote.

    In thinking about this quote, I interpret it as follows - supposing something is true that is in fact true ends up being the same thing.

    I believe that is true, for example - if no traffic is going down the street and I suppose no traffic is going down the street, then when I cross the street everything is ok.

    Yet now I am wondering whether Poincare might be disputed - isn't it the case that even though something is true it is more convenient for us to suppose something else is true instead? For instance, sometimes we use or proffer advice along the "fake it until you make it" lines.

  3. David K. Waltz

    I read your link and have to disagree. As a psychology graduate student, using Freud as an example of good science and theory is ludicrous. Freudianism is not scientific, in fact he makes the exact same mistakes as Friedman, which is to make unrealistic assumptions. Modern psychology is leagues beyond Freud and recognizes that most his assumptions were wrong. When did you go to school? The early 20th century?

    Lost in this discussion is the fact that Friedman's predictions are the exact opposite of what has occurred.
    Therefore, its not a stretch to look at the assumptions of his theories to see if they have any relationship with reality. Low and behold, they don't. Then to find out that he thinks the more unrealistic an assumption is, the better? WTF? To think that other economists use that passage as a justification to assume whatever the hell they want about humans and how we behave is unbelievable.

    Neoliberal economics is actually a lot like Freudianism in that it is not predictive of reality and therefore not a good scientific theory. One only has to look at neoliberal economic policies across the world to see this obvious truth.

    1. Perhaps more is being read into this than intended. Freud's theory was brought up as an example of two things: 1) explanatory ability, and 2) the fact that the elements do not have to be real or true.

      Nowhere are any claims made as to what constitutes "good science" in the field of psychology or economics.

      This example is used because most people, even those without psychology degress (which most readers of this blog are), have at least heard of Freud and are more likely to be familiar with the concept of ego, etc., which hopefully makes the passage relatable for them. That's all.

      With respect to "unrealistic assumptions", all models and theories have them, these are what serve to simplify things to a tractable state. Just because they are unrealistic does not mean they can't be useful.

      Thanks for the comments. Happy to continue the discussion, though preferably without the insulting undertones.