Are your Financial Assets at Risk because your Financial Theory is Fiction?

Do you remember learning about the Scientific Method back in science class?  It has been described as the best way yet discovered for separating the truth from lies and delusion.  The Scientific Method is a logical and rational order of steps by which scientists come to conclusions about the world around them. Sounds pretty smart.  I wonder why the Scientific Method doesn’t exist in the Financial World?

For those of you who were sleeping during that class, the Scientific Method requires the formulation of a hypothesis that is created through observation and tested and reformulated through experimentation.  The end result (if successful) is a theory that can then be open to the scrutiny of peer review – in essence letting everyone else try to shoot holes in your shiny new theory.

The science guys have a pretty good way of doing things.  Sounds like a great way to keep the crack-pots and hucksters where they belong.  If your hypothesis doesn’t work under ALL conditions, it just doesn’t work.

Are your financial assets at risk?

Wouldn’t it be nice if the investment world demanded the same methodology and scrutiny before a new financial theory or strategy was taken as gospel or new product was sold?  How many trillions of investor dollars could have been saved? Unfortunately, the investment world has no (Scientific) Method.

Thanks to the financial media and our own gullibility, all it takes for someone to create a new financial “law” is for someone to write an article or coin a phrase.  For some reason we are quick to accept what we hear.  We may be skeptical in other areas of our lives but when we hear of a new way to guarantee our financial success or an explanation for our current financial woes, we buy it – hook, line, and sinker.  Remember the “New Economy” during the dot.com days?  Or how about the “New Normal” after the 2008 financial crisis?

The world of investing is littered with can’t miss financial products that worked fine until the market for which they were designed changed.  Remember the sub-prime mortgage?  Worked great until housing prices went down.  Didn’t anyone think to test them under this (very likely) scenario?

Are we facing a similar fate with such things as Target Date funds (that failed once before), robo-investing, or so many other financial products and theories that have popped up since the start of this latest bull run?  These products may work now but have they been scrutinized under all possible market conditions?  Remember what happened to all these products that were supposed to manage our risk when the markets tanked in 2008?

What happens when the smartest guys in the world fail?

In 1994 a group of literally the smartest guys in the world of finance came together to create Long Term Capital Management (LTCM).  The group consisted of some of the best of Wall Street, academia, and even two future Nobel Prize winners.  LTCM used complex mathematical models to take advantage of pricing inefficiencies in global government bond markets.  Their reputations allowed them to raise over $1 billion dollars before a trade was even made.

Things started well for LTCM.  Annual returns of over 40% were being achieved.  By the beginning of 1998 success had grown LTCM’s capital from investors to $4.72 billion.  In order to achieve the returns for those assets the firm used massive leverage borrowing $124.5 billion.   In 1998 LTCM was holding derivative positions with a notional value of approximately $1.25 trillion!

Then the unthinkable happened.

The over use of leverage coupled with the East Asian financial crisis of 1997 and the Russian financial crisis (and government bond default) of 1998, led to massive losses for LTCM.  Somehow these brains, some of the best financial minds of the day, didn’t see this coming.  The effects of massive leverage, the difficulties of trading at their current size, and financial meltdown were somehow never tested in their model (or perhaps ignored).  The theories used by LTCM never passed the scrutiny of the Scientific Method and came very close to crashing the world’s financial markets.

If the smartest financial minds in the world can screw up that bad, what does that say for the 10:10 AM interview on CNBC?

What can we do to protect ourselves and safeguard our financial future?

While a major part of LTCM’s problems may have been that they just got too big, this is not the issue with much of the financial products we see today.  We have short memories.  The brokers that sell these products for the financial companies that develop them are quick to capitalize on that fact.  Their job is to lure you with promises of something new and better, and usually exciting – and then sell.  They make it hard for us to say no.  After all, aren’t they the supposed to be the experts?

Are we doomed to repeat this pattern with every market cycle?   We may find – too late – that many of the new products and investing methodologies are developed using bad math that optimizes them to the current market conditions.  Unfortunately, as has been the case many times before, this will most likely lead to the inevitable losses when things change.  And they will change.

Before investing in the next big thing or following someone’s new idea for investing your money, ask yourself what will happen if things really go bad (think 2008).  Does it pass the sniff test and does the person selling you on the idea or product really understand it.  Most of all, does it fit inside your financial plan and do you really need it?

The financial world may not use the Scientific Method but it doesn’t mean that you can’t subject the financial world to a little scrutiny of your own.  As always, let common sense prevail.  Your financial security may depend on it.