Milton Friedman once argued that theory without realistic assumptions or testable hypotheses is useless. By that measure, “80% of financial theory is not fit for purpose,” said Jerome Booth, head at New Sparta Limited, at the 2014 European Investment Conference.
Booth explained that most financial theory models random events as “risk,” in which we presume to know the underlying probability distribution. That construct is fundamentally different from modeling under conditions of “uncertainty,” in which we don’t know the distribution — a distinction emphasised by John Maynard Keynes, who also points out that uncertainty undermines investment incentives for risk takers in the real economy and hence employment and economic growth.
At the same time, however, Booth’s remarks highlighted part of the 20% of financial theory that is fit for purpose. He stated that applying an asset liability management (ALM) framework to investment strategy for private clients has been a passion of his for some time. Wealth managers who make investment recommendations without consideration for the intended use of clients’ capital over time, the size of those liabilities in relation to their assets, or the nature of their other assets (such as human capital) are missing important opportunities to provide truly customised solutions and add identifiable value at a time when automated investment advice is becoming a ubiquitous, low-cost commodity. The same is true for institutional investors.
As Booth outlines in his book Emerging Markets in an Upside Down World: Challenging Perceptions in Asset Allocation and Investment, as well as in his 2014 Financial Analysts Seminar presentation, consumption liabilities of long-term investors in the developed world will increasingly be determined by economic conditions in emerging markets. So, he contends, constructing an asset allocation with this risk exposure in mind is wise.
He predicts that 90% of cars will be produced and used in emerging markets in coming years. Therefore, if prices in the real economy (and hence the basket of goods that monthly pension checks in the United States will purchase) will be largely determined in emerging markets, he believes investors’ assets should hedge this liability. In this sense, Booth argues, emerging market investment is less an active bet that those markets will outperform but rather a sensible risk management tool.
Booth asked the audience why emerging markets are not better represented in Western portfolios. His answer is “cultural bias,” which refers to something he calls “core–periphery disease,” which is the myth that the global core affects the periphery but not the reverse.
In the end, Booth offered no alternative model for the shortfall in financial theory. Rather, his tonic is to combine economic thought, geopolitical awareness, and historical context to develop plausible strategic scenarios and their impact on an investor’s consumption liabilities (whether that investor is institutional or a private client). The only problem with this approach, he says, is that “it’s hard work!”