For centuries, scholars and analysts have attempted to explain the financial market, but for the most part, they fall back on the same mathematical principles that have proven broadly inaccurate. Still, financial provocateurs such as published author and New Frontier Advisors CEO Dr. Richard Michaud are challenging the conventional wisdom and status quo of the financial industry.
Dr. Michaud’s new book, “Finance’s Wrong Turns: A New Foundation for Financial Markets and Social Science,” is an examination of how the finance industry has been approaching portfolio optimization all wrong and how a sociological approach to understanding investor behavior could allow analysts, advisors, and portfolio managers to serve their clients better. By first exposing the flaws of the finance system before proposing his extraordinary solution, Dr. Michaud hopes that he can inspire a revolution in asset management.
Exposing the flaws of the current financial system
The contemporary financial system is primarily based on a series of mathematical axioms that have been around for decades. While this quantitative asset management style is supposedly “tried and true,” Dr. Michaud has found that these metrics may not be as useful or accurate as they are widely believed to be. He argues that the finance sector has taken several “wrong turns” that have caused it to become entirely ineffective.
Ultimately, there has been a cycle of misguidedness created by these financial principles. When many of the commonly accepted axioms were introduced, the technology of the era posed a significant limitation. Now that technology has become significantly more advanced and developed, one would think that financial theories would evolve alongside it.
Unfortunately, much of the technology in the sector is itself based on those outdated principles. As such, it is up to innovators like Dr. Michaud to find new approaches and technologies to solve this problem.
At its core, the process of portfolio optimization widely entails figuring out how people make rational decisions under uncertainty. However, according to Dr. Michaud, attempting to explain this decision-making process in mathematical terms is entirely ineffective. Instead, economists and financial experts should look at these decisions through a sociological lens, as doing so will provide more accurate insight into the group’s behavior.
A new approach to asset management
In his book, Dr. Michaud proposes a revolutionary new way of financial thinking, but his approach isn’t entirely unheard of. Several economists have shared similar perspectives for decades but were largely ignored in favor of the commonly-held-to-be-true mathematical axioms that have since proven inefficient. Dr. Michaud points to important economic theories like Keynes’s “beauty contest” as precursors to his asset management approach.
Compared to the mathematical approach used by many, Dr. Michaud takes a more social-sciences-based approach to asset management. “The stock market should be looked at like it’s a social group,” he explains. “Social groups tend to act differently than the individuals inside of them. However, it is also important to remember the extreme fragility of social groups — a single piece of information can substantially impact their collective behavior. The current mathematical models only help to understand the behavior of individuals. A new approach is necessary to guide understanding of group behavior.”
Dr. Michaud’s new model of portfolio optimization begins by targeting one of the core pillars of portfolio management: the idea of value. In Dr. Michaud’s eyes, this is one of the biggest mistakes the financial industry has made.
“Value is not derived from a series of mathematical axioms,” he explains. “Value comes from the preferences associated with them. For years, scholars have attempted to use mathematical models to understand human behavior, but human behavior is more easily and accurately explained using social sciences. After all, people are people — not numbers.”
From Markowitz to Michaud
“Finance’s Wrong Turns” starts with examining the historical principles that have historically guided the contemporary finance sector before pointing out one theory that has largely been ignored and forgotten by the industry: Markowitz MV optimization. Although Markowitz’s approach has flaws — as any financial theory is bound to — Dr. Michaud says it has tremendous utility as the foundation for a more advanced social-sciences-based approach.
Both Markowitz and Dr. Michaud explored the idea of social preference theory as it relates to the stock market. According to their theories, it is not just individual preferences and opinions that dictate market movement but the understanding of the collective group participating in the market. With the goal of explaining these collective behaviors, Dr. Michaud developed the Michaud efficient frontier, as explained in his book.
As the CEO of New Frontier Advisors, Dr. Michaud has over five decades of experience in asset management, and the theories and methods he presents in “Finances Wrong Turns” are the same ones he has utilized to bring himself and his clients great success. If other financial thinkers follow Dr. Michaud’s lead and re-evaluate their perspectives on value and portfolio optimization through a social sciences-oriented approach, asset management will be revolutionized for the better.