Why Portfolio Management is Screwed Up

 

In his best-selling book The Black Swan; The Impact of the Highly Improbable (Random House, 2007) Nassim Taleb likens what investment brokers, commodities traders, and stock exchange analysts do to snatching nickels from the path of oncoming steam rollers. If I could be so presumptuous as to paraphrase Taleb, another way of putting that would be to say that those who make a living managing portfolios do so while adopting tenets of management theory that are not only flawed, they actually lead to a perspective that prevents the ready identification of profound economic hazards.

In one of my previous blogs, I made reference to a few of these management ideas:

·         The point of all management is to maximize shareholder wealth.

·         Risk Management techniques are applicable to all potential project events, both positive and negative.

·         Quantitative Analysts, or “quants,” on whom the seeming whole of Wall Street investors depend, can consistently generate usable causal analysis of market trends based on observations of thousands of data points pertaining to the various markets.

The first bulleted assumption, which has been pushed by business schools all over academia as irrefutable for decades, is one of the easiest to overturn. Consider what happens during a hostile takeover, as an example. Typically, when a hostile takeover begins, the target company’s stocks jump in value, often significantly. Therefore, if the point of all management was to maximize shareholder wealth, then, in a hostile takeover, no acquiring company would ever follow through on the attempt, and no target company would ever resist. And yet, over and over you see potential target organizations not only failing to sit back and happily watch their company’s equity go up, they will actually engage in tactics that negatively impact their profit and loss statements (like taking a “poison pill”) to avoid the takeover. Clearly, the “maximize shareholder wealth” meme has its limits, but those consultants, accountants, and professors whose paychecks depend on the acceptance of that assertion will never admit as such. And, as such, the theories they propagate that have as a component the maximize shareholder wealth assertion will ultimately prove flawed.

Take also the Risk Management crowd’s basic analysis techniques, the Decision-Tree Analysis and the Monte Carlo simulation. Each requires large amounts of speculation from control account managers, along the lines of identifying potential project-impacting events, their potential impact, and the odds of their occurrence. Once these numbers are collected, the Risk Management aficionados simply love crunching those numbers in various formulas (which, invariably at some point pull in a Gaussian curve) and pretend to deliver some quantification of how the project’s future will unfold. This fails for two very simple reasons:

·         The data used to feed these analyses is pure speculation, and

·         The future cannot be quantified.

As for the quants, they may have been absent from statistics class the day their professors made clear that correlation is NOT causation (generally stated at the beginning of the first day of class). Instead, they pore over massive amounts of data associated with their areas of investment, seeking to place causal links between predecessor events and successor changes in wealth creation or destruction. Then, when they believe they have discovered a certain causal loop, they will make recommendations one way or the other when the presumed causal predecessor events manifest again. I’m not saying they're stupid – far from it. I’m going, however, to paraphrase Ronald Reagan, and say that they just know lots of things that just ain’t so.

With management “science” notions such as these (among many) influencing the current academic debate (not to mention the myriad software platforms) on what constitutes portfolio management, it’s no wonder they entire area of discussion is completely, well, screwed up. Want to know how to navigate your way to a legitimate portfolio management system? Either order my recently-released, must-have book Game Theory in Management (Gower Publishing, 2012), or stay tuned to this blog. The former will give you your answers immediately, the latter will take a bit more time.