Why Money Management Will Have to Change, Part 3
We continue with why money management will have to change. I'm going to bring in none other than Paul Krugman here. This might get a little technical, but then again, money managment can get a little technical sometimes.
Krugman wrote a pretty interesting (albeit kind of long) article in the Sunday New York Times a few weeks ago. He's was trying to explain why so many economists missed the financial crisis of 2007-2008 (which we believe continues even now), as well as the recession that started in 2007. I guess he was kind of embarrassed for himself and others, whom he clearly thinks are pretty bright people.
What concerns us here are his comments about Eugene Fama and the efficient market hypothesis." That's a theory that says that markets are efficient. It means that markets price items efficiently all the time. And so prices in markets basically reflect exactly the right value for a given item at every moment in time.
Lots of money managers believe this theory. (We don't know if any have changed their minds as a result of 2007-2008). And these folks manage lots of money - much of which they lost in 2007-2008.
In fact, modern portfolio theory, another theory that influences a lot of money managers, is based in part on this "efficient market hypothesis" and its cousin the "Capital Market Pricing Model" (CAPM).
Okay, enough technical stuff. Here's the main point.
Krugman's saying the efficient market hypothesis theory has to be questioned, as does CAPM. He's not saying modern portfolio theory has to be questioned, but that's a logical implication of Krugman's article.
What that means to us is that money managers shouldn't rely on modern portfolio theory in what I've thought was a kind of blind acceptance. It's based on faulty assumptions. Most important, a reliance on modern portfolio theory resulted in "the big loss" for lots of folks whose money managers relied on it recently.
So you've to to think that money management that relied the efficient market hypothesis, CAPM or modern portfolio theory will have to change. Makes sense, doesn't it? The theory didn't work out in practice. So check that theory now.
Krugman wrote a pretty interesting (albeit kind of long) article in the Sunday New York Times a few weeks ago. He's was trying to explain why so many economists missed the financial crisis of 2007-2008 (which we believe continues even now), as well as the recession that started in 2007. I guess he was kind of embarrassed for himself and others, whom he clearly thinks are pretty bright people.
What concerns us here are his comments about Eugene Fama and the efficient market hypothesis." That's a theory that says that markets are efficient. It means that markets price items efficiently all the time. And so prices in markets basically reflect exactly the right value for a given item at every moment in time.
Lots of money managers believe this theory. (We don't know if any have changed their minds as a result of 2007-2008). And these folks manage lots of money - much of which they lost in 2007-2008.
In fact, modern portfolio theory, another theory that influences a lot of money managers, is based in part on this "efficient market hypothesis" and its cousin the "Capital Market Pricing Model" (CAPM).
Okay, enough technical stuff. Here's the main point.
Krugman's saying the efficient market hypothesis theory has to be questioned, as does CAPM. He's not saying modern portfolio theory has to be questioned, but that's a logical implication of Krugman's article.
What that means to us is that money managers shouldn't rely on modern portfolio theory in what I've thought was a kind of blind acceptance. It's based on faulty assumptions. Most important, a reliance on modern portfolio theory resulted in "the big loss" for lots of folks whose money managers relied on it recently.
So you've to to think that money management that relied the efficient market hypothesis, CAPM or modern portfolio theory will have to change. Makes sense, doesn't it? The theory didn't work out in practice. So check that theory now.
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