The financial market is one of the world’s most complicated mysteries, and for centuries, many scholars have attempted to explain it in various ways. Conventional financial theory is more mathematical in nature, but several innovators in the field have challenged these guiding principles and proposed alternative perspectives on portfolio optimization.
One such financial provocateur is Dr. Richard Michaud, published author and the CEO of New Frontier Advisors.
Finance’s Wrong Turns
Dr. Michaud has just released his new book, “Finance’s Wrong Turns: A New Foundation for Financial Markets and Social Science.” In the book, he analyzes what the finance industry has gotten right and what needs improvement by evaluating the sociological principles that dictate investor behavior. Over his more than five decades of experience as an asset manager, Dr. Michaud has come to a keen understanding of the core behaviors of financial markets and how analysts, advisors, and portfolio managers can use these new and improved strategies on behalf of their clients.
As it stands, the finance industry is heavily based on a mathematical approach centered around concepts and theories that have been around for decades. However, this quantitative asset management style has significant limitations that Dr. Michaud points out in his book. Portfolio optimization aims to understand how people make rational decisions under uncertainty, but according to Dr. Michaud, explaining these decisions in mathematical terms is futile. Instead, economists should look at these decisions as they are made from a sociological perspective.
Reapproaching the idea of value
“Fundamentally, the central pillar of the finance industry is the idea of value; however, one of the gravest mistakes that the financial sector has made is thinking about value incorrectly,” Dr. Michaud asserts. “Value doesn’t come from a series of mathematical axioms, but the preferences associated with them. Although understanding those axioms can be important, time has shown that they alone are not effective in determining portfolio value and optimizing portfolio performance.”
Dr. Michaud begins the book by taking the reader through a brief history of the different financial theories that have dictated portfolio optimization for decades before evaluating the method that has unfortunately been forgotten: Markowitz MV optimization. Although Dr. Michaud points out some critical flaws in Markowitz’s theory, he uses it as the foundation for his revolutionary new approach to asset management and portfolio optimization.
Markowitz’s approach — as well as Dr. Michaud’s — is based on a more social sciences-oriented approach to financial markets. Markowitz and Dr. Michaud both heavily emphasize the importance of social preference theory when analyzing financial markets. In other words, it’s not just individual opinions and preferences that dictate market movement but group and societal understandings.
Social preference theory in the financial market
Dr. Michaud asserts that a social sciences-based approach is not as novel as it may seem — the economists who have proposed similar approaches for decades have been mainly ignored. He points to a theory proposed by John Maynard Keynes that compares financial markets to a beauty contest.
“In Keynes’s theory, judges in a beauty contest were rewarded more for selecting the most popular face, rather than the one to their own preferences,” explains Dr. Michaud. “In terms of financial markets, that means that it isn’t about what the individual thinks is a good stock, but what the market controllers think is a good stock, having a profound ripple effect.”
In his book, Dr. Michaud suggests looking at the stock market as one would a social group, as social groups tend to act differently than the individuals inside of them. However, social groups are also highly volatile and fragile — one single piece of information can fundamentally change the social group’s behavior. As such, it is crucial to understand that portfolio optimization does not involve understanding the behavior of individuals, which would be addressed by the current mathematical models of the financial market, but the group’s behavior.
How technology has enabled a new paradigm in financial theory
Ultimately, a key component of the issue regarding the finance industry today is that it is based on a cycle of outdated axioms. “Back when people like Sharpe introduced these theories, the technology was extremely limited and has since become outdated,” Dr. Michaud explains. “However, modern technology is now based on the theories of these scholars who worked with outdated technology. As such, correcting these errors in finance involves us going back to basics and re-evaluating what we know through an entirely different lens.”
Still, Dr. Michaud and his team at New Frontier Advisors have been able to develop patented technology using their guiding principle of the Michaud Efficient Frontier, which he explains extensively in the book. With this innovative new framework and technology, Dr. Michaud hopes to inspire other thinkers in the financial space not to limit their perspectives to those traditionally accepted by the industry — as this will only limit their capabilities to optimize portfolios efficiently.
