Print this article

BOOK REVIEW: Douglas Adams, False Views Of Risk - And The Goon Show

Tom Burroughes

7 July 2014

It is sometimes said that in the aftermath of the worst financial crisis since the Great Depression, a lot of the assumptions of finance professionals have been thrown onto the ash heap. But almost six years on from this episode, with central bank confetti money driving equities back upwards, is there a risk that a lot of the hard lessons might not be learned?

Not if Guy Fraser-Sampson has anything to do with it. Fraser-Sampson, a senior investment professional and senior fellow at the Cass Business School in the City of London, and a public speaker and commentator, has produced a new book, The Pillars of Finance: The Misalignment of Finance Theory and Investment Practice (published by Palgrave). In this 260-page book, Fraser-Sampson takes aim at what he calls Finance World, a place where, since the end of the Second World War, many assumptions about how investments should be understood have come to be associated with mathematical models aiming at what he sees as a spurious level of certainty.

He argues that modern financial theory is out of line with reality; it ignores the uncertainties and subjectivity of human action, and its treatment of risk, return and value is completely wrong. For example, he argues that measures such as annualised equity returns commit the error of ignoring the time value of money. It makes no sense, he says, to overlook that the value of an investment will depend a great deal on the time preference a person has for money – some value having their money right now more than others; annualised returns don’t capture this point. (Without understanding of how time matters in understanding demand for money, one cannot understand interest rates and the capital structure of an economy, for example.) Far better, Fraser-Sampson says, to use measures such as internal rates of return (commonly used in private equity) since IRR takes into account the timing of deals and the timing of when assets are put to work and when they are turned into cash.

The book explores a point one has heard several times recently: namely, that risk and volatility aren’t the same thing at all. After all, if volatility is variation about a mean level, then when a price is above an average, how is this risky? In understanding risk, Fraser-Sampson says, one needs to see the question: risk of what? Risk, according to most dictionary definitions, means something unpleasant or harmful, such as the risk of getting seriously ill. In finance, a way to think of risk is the possibility of not having the money one needs to meet one’s objectives, such as having enough to cover potential pension liabilities, or pay for one’s children’s school fees, etc. But clearly, if risk is seen in this way, it is much harder to come up with a neat mathematical definition of risk, although there is nothing necessarily wrong with trying to explain certain risks by using numbers. So long as the limitations of this are understood and honestly appreciated.

We have seen how, for example, certain models of risk, when used as a basis for some of the products associated with 2008 crash, have led bankers astray. Value at risk, for example, based on bell-curved shaped distribution of risk, turned out to have massively underestimated the kind of events that occurred. Investors who put their faith in the risk models employed by banks, hedge funds and others got badly burned.

Fraser-Sampson does not just take aim at modern finance theory. He also sketches out what he sees as a better way for teachers of finance (which he disputes has the standing of a science) to operate. There needs to be more of an interdisciplinary approach: teachers of finance should, for example, pay more heed to what is known as behavioural studies and an understanding of the foibles and irrationalism of human behaviour. (This is an area still very much a case of work in progress.) Above all, he says, teachers of finance, and their students, need to understand that old Socratic point that the beginning of wisdom is in understanding how ignorant one inevitably is about many things.

This book quite consciously is set out as a challenge to what is seen as an established way of thinking and doing things, and no doubt some of Guy Fraser-Sampson’s arguments will jar with those used to thinking in terms of Sharp Ratios and VaRs. I follow him on just about most of the arguments, although I might quibble a bit about his invoking of the philosophy of Immanuel Kant, the 18th century German thinker who argued that it is never possible for humans to arrive at objective knowledge of the external world. This view, Fraser-Sampson says, means that it is not possible to arrive at an objective view of what lies outside of us, so we have to make do with subjectivity. Is this really the case? After all, the book itself makes a number of statements about different personality types, and does so with a fair degree of certainty, so presumably these comments by the author aren't just meant as subjective viewpoints, but a statement of truth, to some extent. Any statement about X or Y being X or Y is, presumably, an attempt to say something one feels is objectively true. I am sitting in front of my laptop and typing these words - I happen to believe that is a fact, not just my personal opinion.

Even so, I generally like how Fraser-Sampson veers off the usual economics and finance terrain to make his points. And a willingness to go quite far off the usual path is welcome. He uses a variety of sources - even Douglas Adams. Frankly, any book that can weave in insights from Adams' Hitchhiker's Guide to the Galaxy, the insights of Austrian economics genius Ludwig von Mises, and a line from 1950s hit radio series, The Goon Show, deserves to be widely read.