Investing with the Trend: A Rules-based Approach to Money Management

Chapter 3Flaws in Modern Financial Theory

As an aerospace engineer, my education kept me far removed from the world of finance. Over the past couple of decades my career dropped me solidly into the “world of finance.” The world of finance is my baked-up term that includes financial academia and, in general, retail (sell side) Wall Street. I honestly believe that the former is the marketing department of the latter.

In engineering we knew that to begin an analysis or delve into a research project, we had to begin with some basic assumptions about things. These assumptions were the starting blocks for the project; they launch the process. Many times, well into the project, it would be obvious that some of the assumptions were just wrong and had to be corrected or removed. The World of Finance over the past 60 years has produced a large number of white papers on financial theories, many of which begin with some basic assumptions. So far, so good!

1. The markets are efficient.
2. Investors are rational.
3. Returns are random.
4. Returns are normally distributed.
5. Gaussian (bell-curve) statistics is appropriate for use in finance/investing.
6. Alpha and beta are independent of correlation.
7. Volatility is risk.
8. Is a 60 percent equity/40 percent fixed income appropriate?
9. Compare forward (guesses) Price Earnings (PE) with long-term trailing (reported) PE.

The remainder of this section covers the challenges I have to the above list. Personally, I think modern finance is almost a hoax, an area of investments ...