"In Theory" Pt. 1

"In theory..." -the two favorite words of any professor, and the bane of any investment professional attempting to justify their analysis or decision. The two words, "in theory", represent so many assumptions and suspensions of reality that we seldom stop to think about how they impact our decision making process in the real world. Although modern finance owes a great deal to past theoreticians like Modigliani and Miller, Fischer, or even Black and Scholes, these theories have been the downfall of countless practitioners who have forgotten to question the whether the assumptions that underly these theories are correct.

Like a size-o model walking down the runway and representing an "ideal", academic models rarely reflect the messier and, lets face it, uglier version of life that we call reality. In this column, we'll explore the key distinctions between the much-vaunted products of the ivory towers with the day-to-day operations of a modern investment analyst, fund manager, or central banker.

Despite cautions against taking academic models for granted, we frequently see financial players throw up their hands in disbelief -even abject horror- that they had been led astray by their finance textbooks. When financial models are based on "two standard deviations" and "a 95% chance nothing will go wrong", we should not be surprised that a financial crisis seems to recur every 20th year (Hey, the other 95% of the time we were coining money...before we went broke). Models can be made for any assumption: equilibrium, perfect competition, perfect information, arms-length transactions, rational actors. Ask any finance professional worth their salt if their equilibrium model ever helped them make a successful decision.

Should we despair then, and simply throw darts at a board to pick stocks or forecast growth and interest rates? Certainly not. But as responsible managers, we are obliged to perform due diligence that stretches beyond the balance sheets and balance of payments. We are obliged to always question our own assumptions, not with cynicism but with healthy skepticism. And we are obliged to dust off our textbooks and ask the crucial questions: "What happens if my assumptions are incorrect? What does this mean for my decisions?"

With these initial questions in mind about our fiduciary responsibilities, we'll return on our next post to compare some popular academic theories to past successes and failures. With credit to Lane Barrow: In theory, there is no difference between theory and practice. In practice, there is.

Brian Rozental is a 2nd Year MBA student at the University of Connecticut and a Vice President of the MBA Finance Club.