Through the Fog of Crisis: The Future of Finance

For investors across demographic categories and risk-tolerance profiles, seeking alpha seems an increasingly humbling ambition. Like a robot whose behavior deviates from its program, the global financial system continually subverts not only exotic strategies but also established orthodoxies that claim to point the way to superior risk-adjusted returns.

It hasn’t spared the grand theories of classical finance (e.g., Modern Portfolio Theory, Efficient Market Hypothesis) and their elaborate system of hypothesized relationships between value drivers and risk-adjusted returns. Events once confidently classified as “Black Swans” now better fit the definition of routine anomalies that accentuate the deepening epistemic crisis of modern finance.

At the same time, the regulatory framework still struggles to modernize and address mounting political pressures with dwindling resources. Obsolete accounting standards still materially distort asset values. Burgeoning “Big Data” still far exceeds processing capacity. The blurring of traditional demarcations between asset classes, industries, securities markets and indexes has birthed a growing ecosystem of ETFs and other investment products luring investors with the promise of highly tailored exposure to alpha drivers. With access to these products increasingly democratized, alpha remains elusive.

Finally, the integration of sustainability factors into mainstream institutional portfolios is redefining bedrock investing concepts such as risk and reward, particularly as Millennials gain share of voice in the financial community.

But promising innovations do arise from the wreckage of old ideas, sclerotic institutions and academic theories assaulted by brutal facts. Take, for example the idea of social capital. Last week, WSJ profiled Instavest, a social-investing startup that allows investors to crowdsource and share ideas, coinvest, form pools of funds and compensate each other from a single platform.

The VC interest in Instavest reflects a broader recognition that new technologies and easy access to data analytics are changing investment analysis as deeply as Kindle changed the experience of reading. In the age of social media, all investing is social and seeking alpha is an equal-opportunity and highly affordable sport. Most importantly, transparency is slowly becoming the norm in performance reporting, and investing is becoming more of what it needs to be: a meritocracy.

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recommended-reading-2Instavest: The Startup That Wants to Uproot Hedge Funds (WSJ, 10/24/2016)

…Instavest would live or die on the network effect: Better ideas rise from a larger base. More users would increase the likelihood of uncovering that diamond-in-the-rough investor, who would in turn attract more users. “I’m willing to bet there’s a guy working a New York City pizza joint who’s a better investor than the guy sitting on Park Avenue,” Graham told them. He turned to Khatri. “Find me that person.”

Pizza-Joint Investors and High-Speed Traders (Bloomberg, 10/25/2016)

But why would it be easier to identify in advance which pizza guys will consistently beat the market? It’s fine to be skeptical of the investing skills of professional investors, but that is a reason to index. It is not in itself a reason to be enthusiastic about the investing skills of amateurs.

Book Review: Is Forecasting A General Skillset? (MarketMinder, 10/26/2016)

Within all this is a message most will miss: Tetlock found that simplicity is essential to forecasting. Consistently, the best forecasters don’t use sophisticated statistical approaches, and anything beyond basic data crunching is usually a misapprehension of reality. Reality is vastly complex; but to churn its possibilities through a human mind requires the disciplined arrow of simplicity. Otherwise, we wander and lose the thread of reality.

The Danger of Having Too Many Experts (TIME, 10/27/2016)

It is this multidimensional complexity of modern day problems that diminishes the salience of singular expertise. Contemporary challenges like income inequality, climate change, healthcare access and policing strategy cannot be solved by narrow technical specialists, each swimming in their own lanes. To meet these challenges, specialist expertise is often necessary but certainly not sufficient.

Superforecasting: How to Upgrade Your Company’s Judgment (HBR, May 2016)

The sweet spot that companies should focus on is forecasts for which some data, logic, and analysis can be used but seasoned judgment and careful questioning also play key roles.