25.1 Introduction

During the tenth century, Saint Anselm of Aosta, Archbishop of Canterbury, pointed out in his address on the existence of God: “For I do not seek to understand in order to believe, but I believe in order to understand.¹” In 1994, the French writer André Frossard, a friend of Pope Jean Paul II, aptly reformulated the famous saying: “Faith is what enables intelligence to live above its means.” André Frossard surely did not imagine that one day his mischievous pirouette would be diverted and applied to the theory of finance: “Faith (in its models) is what enables the theory of finance to live beyond its means (disconnected from reality).”

25.2 “Anselmist” Finance

Just like their cousins the economists, practically all financial theorists have adopted an “Anselmist” posture; they believe in order to understand. They believe in their models, so they expend countless hours refining and mathematically schematizing. Their addiction to models would not be essential if the consequences remained confined to their ivory towers. Unfortunately, the academic word has been taken into ever greater account, and theoretical models feed into the thoughts and actions of our quotidian practitioners and governing authorities. The situation is disconcertingly ironic. For once, theory and practice enjoy neighborly relations; we ought to jubilate over the exceptional proximity between the work of theorists and its practical application. Even so, wariness is in order; their proximity is hardly above suspicion. When all is said and told, financial theory is partially responsible for the crisis² that punctuated the end of the so-called aughties.

Such frequent adoption of a “credo ut intelligam” posture is all the more surprising given the profusion of financial data at our disposal today. Everything happens as if the experts had decided to shoehorn the data to conform to the models, even though a less flamboyant but more effective strategy would consist in teasing out the data by attempting to grasp them, and in questioning investors and savers so as to find sound reasons for intellectual inspiration. The repeatedly told story of a 20-Euro bill lying on the sidewalk untouched is, from this standpoint, distinctly revelatory. For the theorist who believes in market efficiency, there cannot possibly be any bill littering the ground; if there were an actual bank note, some pedestrian would surely have picked it up! But facts being facts, there is indeed a bill down on the ground. And so, what is to be done? Are we to believe in the model and pass for mental defectives by leaving the bill alone, or are we to pick it up and look into the possible reasons why it had yet to be put in anyone's pocket? Needless to say, the question posed in this anecdote is inoffensive, and the answers are inconsequential, but what happens when the stakes are incommensurably higher?

What's essentially at stake, of course, is our understanding of the behavior of the economic actors, which means producers, consumers, investors, and others. Financial theorists have developed heavy artillery designed to model the risk-related behavior of economic agents. In a nutshell, the latter are viewed as paragons of Homo Economicus, whose main characteristic is to privilege any actions that would maximize their expected utility with regard to future consumption. Expectation or hope for that matter is the watchword, for nothing could be less certain than the future, and it makes more sense to fall back on the ancient principle of mathematical expectation prized by Blaise Pascal. Utility is what matters, for it is not consumption per se that counts, but rather the greater or lesser satisfaction it brings. The financial theorist couldn't care less about Homo Sapiens; only Homo Economicus is of passionate interest. Homo Economicus is a methodical, unwavering, rational calculator whose company is appreciated by the theorist with his models. However, Amartya Sen, a Nobel Prize winner in economics and stalwart critic of all-purpose rationality, has observed that the cold calculator is devoid of nuance. His reckoning can produce adverse outcomes both as far as he's concerned and with respect to the general interest. The divorce between individual intention and individual or group-centered results is metaphorically and tragically typified when fire in a night club occasions mass movements of panic. The Belgian daily Le Soir published an article³ on a conflagration in the “5–7” dancing hall of Saint-Laurent-du-Pont:

“At Saint-Laurent-du-Pont, not far from Grenoble, France, hundreds of young people had come to the dancing hall known as ‘le 5–7.’ All of a sudden at 1:45 a.m., the lights went out. Flames had arisen from part of a ceiling. They had all but instantly wrought havoc on the sumptuous decor of the club, which was configured like a grotto with a multitude of plastic panels. The plastic caught fire and melted. The entire hall was engulfed in flames within a few seconds. Monstrously panic-stricken persons in the dozens crammed themselves in front of the three exits. All of them were too small, and two doors were sealed off (so as to keep free riders out), while a third was barred with a turnstile that was quickly blocked by the surge of the panicky crowd. In front of the three doors, in particular, and throughout the club, there were 146 lifeless bodies of young people grounded and pounded to death by human stupidity.”

25.3 Casino or Dance Hall?

Dance hall fire stories invariably follow the same plot: the outcome is fatal. Once the alarm resounds, panic pervades. All the customers converge simultaneously and savagely either toward the limited number of emergency exits or, more simply and reflexively, toward the door through which they had entered. The individual movements transformed into a hysteria-crazed human tide are unfortunately lethal. They tragically lengthen the number of victims. As each person desperately attempts to save his skin, he dooms himself and also condemns countless others. We wind up coming to a paradoxical conclusion: Emergency exits only function effectively when they are not needed. Conversely, they fail to fulfill their function when the fire alarm goes off and panic sets in.

So it goes with financial crises as well as dance halls, and one wishes that the theorists of finance had a more clinical approach to crises and were consequently better able to understand the risk of which they claim to be the specialists. Risk perceived from the ivory tower has nothing to do with the risk that blows billions of dollars away. Eminent researchers in the field of finance have nonetheless made risk and emergency exits the foundation on which the entire edifice has been erected. In the language of finance, the emergency exit is known and lauded as a well-diversified portfolio. To avoid breaking your eggs all at once, you must not put them in the same basket. This academic prescription came into being in the works of Harry Markowitz, professor at the City University of New York (and winner of the Nobel Prize in economics in 1990). Markowitz takes exception to Mark Twain, who humorously wrote: « Put all your eggs in one basket – and watch that basket!! » On the contrary, Markowitz urges investors to multiply their baskets, to diversify the composition of their portfolios. To sum up, an investor applying the prescriptions of the good Doctor Markowitz sleeps better than an investor following the advice of Mark Twain. Ownership of multiple shares in the same portfolio allows him not to worry about the highs and lows of any stock in particular. If one of them is falling, then he is bound to find another of which the rise will not fail to compensate for the attendant losses. Diversification is consequently the most efficient way to extinguish fires, and it is the cornerstone, the fundamental credo, of financial theory.

Such is the foundation that modern portfolio and asset assessment theory have built. Put to the test of fire, however, diversification is far from having fulfilled its promises. The 2008–2009 crisis is a patent example. The portfolios of investors all over the world underwent staggering monumental losses, far higher in any case than prudent diversification would have allowed them to imagine. Everything fell precipitately at the same time, entangling the portfolios in a devastating downward spiral. When crisis arose, the financial markets behaved like a gigantic night club with grossly under-dimensioned emergency exits. At the very moment when the need for diversification was of utmost urgency, it was nowhere to be found, and it became saddeningly obvious that diversification functions only when it is superfluous, that is to say, when stock market fluctuations remain reasonable. As soon as the fluctuations grow wild, panic and havoc ensue, as seemingly crazed investors run willy-nilly for their lives.⁴ The instantaneous switch from mild randomness to wild randomness (to borrow the terminology of Benoît Mandelbrot) undermines the assumed benefits of diversification. The study of idiosyncratic and market risk in the long run delivers additional evidence that portfolio diversification is indeed much less effective than what it used to be at the beginning of the twentieth century (see Le Bris (2012) for instance on the French stock market). The consequent damage has several interconnected causes that financial theory, enveloped and consumed by its credo, has unfailingly omitted from its models.

25.4 Simple-Minded Diversification

The first of these causes is the “Black Swan” of Nassim Taleb (2010), the rare and unpredictable event, the improbable “outlier” with its drastic consequences that have not been factored into hypothesis-based theory. Theory is effective for mild risks highly concentrated around an average value, as is the case in Gauss's law. Of course fluctuations occur, but they show the good taste not to stray too far from the mean. Actual facts, however, belie the assumption that risks are mild. From 1916 through 2003, in accordance with the Gaussian hypothesis there should have been 58 days in which Dow Jones variations would have exceeded 3.4%, but in reality, they numbered 1001! Other salient examples would be easy to cite. For instance, François Longin (1996), again using extreme value theory, provides rich evidence that extreme values do matter and that the Gaussian assumption so frequently made is pure nonsense. It is worthwhile noting that Longin (1996) observes that “little attention has been given to extreme movements themselves.” (p. 384). The stock market is wilder than theory assumes (or feigns to believe).

The worst is yet to come. Wildness cannot be dissociated from the peculiar herding behavior shown by investors. Risk is not some exogenous datum with which investors are confronted and that they try to rein in through diversification. It is only slightly a caricature to say that investors embody risk; they are their own worst enemies. During tranquil periods they tend to ignore one another, which means that are not preoccupied with the impact their behavior will have on others. During a turbulent period, as happens when a dance hall catches fire, debacle calls for more debacle. Each investor has a pressing need for liquid funds at exactly the same time. Sell orders pile up and trigger a vicious circle, which gains additional traction through the regulations that require investors to recapitalize in proportion to their losses. While all the eggs may not be in the same basket, all the investors find themselves caught at the same time in the same trap.

Finally, a more subtle yet far from negligible effect is engendered by diversification. To be precise, it is derived from the double credo of diversification and from the principle according to which the financial market is efficient, and cannot be beaten. The consequences to be drawn from these duel tenets are potentially deleterious, insofar as theory converts them into the simplest of prescriptions: Since as a matter of principle you cannot beat the market and since it is imperative to shield yourself from risk as best you can, an investor should not only hold but also hold onto a diversified portfolio, that is to say he must refrain from buying or selling. In the long run, after all, it will pay off! It suffices to be patient, to leave time for time, and mutual funds (among other diversified stock market investments) will wind up reaping their fruits. All other things being equal, the underlying philosophy reminds us of the exhortations proffered by the Israeli Prime Minister Itzhak Shamir at the height of the First Gulf War at a time when SCUD missiles were targeting Israel, possibly with nerve agents such as sarin. A journalist asked him: “Mr. Prime Minister, what have you to say to your Israeli fellow citizens?” Shamir answered: “Be brave!” The journalist went on: “What have you to say to the Palestinians living in Israel?” His answer: “Keep calm!”

In the final analysis, what the portfolio theory requests from investors is that come what may, they be simultaneously Israeli and Palestinian, brave and sedate at the same time. Analogously, even when risk is indeed mild, the investing passivity recommended in theory is tantamount to our signing a blank check and addressing it to the institutions placed in charge of producing the mutual funds of which we patiently await the dividends. But who can assure us that these institutions have their pendulum synchronized with ours? The diversification advised by Markowitz has nothing to say on the subject, and it proceeds as though the institutions were neutral and transparent sails. But the role of financial institutions is not only primordial, but often massively destructive. The diversification recommended by theorists takes place in total financial asepsis; it is as though the institutions in charge of our money were not only transparent but also beneficent! Of course, there are a number of researchers who have made a specialty of analyzing the conflicts of interest inexorably brought about by institutions bringing together a wide variety of stakeholders. One may nonetheless regret that the loop has not been closed and that the theoretical precept of diversification is still placed on an uncontested pedestal. Whatever may occur, belief in passive diversification somehow remains essential to understanding. Given this, it is baffling to note the elevated frequency of market transactions; after all, the stock market is anything but passive. The Anselmist theorist is prone to brush aside this inconvenient fact: Don't the transactions originate with investors showing excessive confidence in their financial capacities?

25.5 Homo Sapiens Versus Homo Economicus

Such excessive confidence brings us back to the field of psychology, in which the subject to be studied is not Homo Economicus but rather Homo Sapiens. Andrew Lo, a Professor of Finance at MIT and one of the few iconoclasts of academic finance, excellently summarizes the different approaches separating psychology and economic science. Psychology is based mainly on observation and experimentation. Field studies are frequent, and empirical analysis leads to new theories. Psychology postulates several theories of behavior and its priority is not to achieve coherence between them. Contrastingly, economic science is founded on theory and abstraction. Field studies are few and far between. The theories lead to empirical analysis. There are not many theories on behavior, and coherence between theories is a key factor. To sum up, psychology is not Anselmist: It does not believe in order to understand. It tries to understand, and then may go on to believe. Economic science and financial theory are largely Anselmist: First they fervently believe, and only later (much later?) do they try to understand. And when they fail to understand, since the model has not been validated by the available data, they are by no means inclined to throw out the model. In economics as in finance, throwing things out is anathema!

Keynes had the habit of saying that many of us are “the slaves of some defunct economist.” He did not realize how right he was! The “credo ut intelligam” can indeed be imputed to a famed and recently deceased economist, Paul Anthony Samuelson, whose manual in economics has sold millions of copies. A professor at MIT and the first Nobel Prize winner in economics, Samuelson stamped a lasting imprint on the discipline of economics and the researchers who have dedicated themselves to the field. The title of his 1947 thesis is anything but ambiguous: Foundations of Economic Analysis. His clearly enunciated ambition is to elaborate a coherent mathematical framework applicable to all sectors of the economy, starting with the area most propitious to such treatment: microeconomics. Samuelson seemed to be on fine terms with his inner physicist. As Andrew Lo⁵ rather maliciously points out, economists in general, and financial theorists in particular, are prone to physics envy: “In physics, it takes three laws to explain 99% of the data; in finance, it takes more than 99 laws to explain about 3%.”

The agenda put forward by Samuelson in 1947 bore the imprint of physics and was pervaded with the hope of discovering a few laws that would explain everything and create lasting foundations for a religion of economics and finance. Unfortunately and notwithstanding all the respect we may have for the numerous intellectual contributions of Samuelson, his agenda started off on the wrong track; the analogy with physics is misleading. The economy and the financial markets are not physical systems; they function differently, and there is a good reason why. The economy is made up of human interactions that are in no way comparable to those of particles suspended in a fluid. Each morning on the radio station BFM, Marc Fiorentino⁶ analyzes the “fundamentals” that shape and form the economy from one day to the next. But there's more to it than that. If that were just that, then Samuelson and his apostles would have had more success. In fact, what matters most is how agents consider the fundamentals, what they think of the reactions of the other agents with respect to the ABCs, and so on. Such complex human phenomena do not exist in physics, the laws of which are robust, and do not vary according to what happened on the financial markets over the previous month. Economic laws, which means those of economists, are constantly modified, and that is why a « credo ut intelligam » posture is at best fruitless, and at worst hazardous.

It is past time to adopt a new approach and to make « intelligam » the priority. This will be no easy task; the academic powers-that-be will not readily allow their PhD students to be iconoclasts. This is a shame, for they ought to be encouraging their students to constantly contest the established order; in so doing, of course, the mandarins would embrace the risk of seeing their own work taken to task and invalidated, from one day to the next.

Acknowledgement

We thank François Longin for his helpful comments and suggestions.

References

1. Bourguinat, H., Briys, E. L'arrogance de la finance. Paris: Editions de La Découverte; 2009.
2. Bourguinat, H., Briys, E. Marchés de dupes: pourquoi la crise se prolonge. Paris: Editions Maxima; 2010.
3. Le Bris, D. Is the Portfolio Effect Ending? Idiosyncratic risk and market risk over the long run, BEM Working Paper; 2012. Available at http://ssrn.com/abstract=1723162.
4. Longin, F. The asymptotic distribution of extreme stock market returns. Journal of Business 1996;63:383–408.
5. Longin, F., Solnik, B. Extreme correlation of international equity markets. The Journal of Finance 2001;56:651–678.
6. Taleb, N. The Black Swan: The Impact of the Highly Improbable. New York: Random House; 2010.