Are financial theories useless & dangerous?

Apr 9, 2012

In this issue:
» State governments better than Centre on fiscal front
» The secret why Goldman Sachs is always right
» Why are so many flats lying vacant in Maharashtra?
» Will the US manufacturing industry revive?
» ...and more!

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We are living in times when formal education has almost become a basic necessity. Much of what goes on in the world of business and finance is a result of what is taught inside classrooms. So when there is a problem outside, one needs to pay careful attention to what the professors are teaching.

Take for instance the ongoing economic and financial crises that kicked off with the bursting of the US housing bubble in 2007. It was more than just a consequence of the greed and ignorance of investment bankers and policymakers. It was a blatant expose of the several flaws in the theories of modern finance. Who would be a better person to point this out other than Mr Nassim Taleb, himself a professor of risk engineering and author of the highly acclaimed book Black Swan?

According to him, highly sophisticated and complex financial models are useless in predicting rare but highly impactful events. In fact, they are extremely dangerous. He gives a very interesting analogy to explain his point. Say you are a passenger on an airplane. The pilot comes up to you and says that his map is a bit faulty. But that is the best map available. Would you still want to take a ride on such an airplane? Certainly not! Unfortunately, the financial world often rides on half-cooked theories.

Whether risk managers, investment bankers and finance professors will learn their lessons is a different thing. But any such crisis is a great opportunity for investors to learn some very important lessons. One, it is always best to keep things simple. Using complex tools to understand complex phenomena is often not the right way to take. That is why we strongly believe in the value investing approach propagated by Warren Buffett, Benjamin Graham, Peter Lynch and the likes. Because of its simplicity yet firm adherence to solid principles, it eliminates several risks that a complex approach would fail to account for.

Do you think value investing is the most durable approach to investing? Share your comments with us or post your views on Facebook page / Google+ page.

 Chart of the day
The Indian Union government may be struggling to reign over the bulging fiscal deficit. But recently released data indicates that state government finances are in a better shape. In fact, in its annual analysis, the Reserve Bank of India (RBI) has stated that barring 5 states, all other states are expected to generate a revenue surplus. Today's chart of the day shows the three best performing states (non-special category) on the fiscal deficit front. As the chart shows, the fiscal deficit of Maharashtra, Gujarat and Bihar is expected to come down appreciably. However, it must be noted that the compression in expenditure is most likely a result of reduced social sector spending.

Data source: Mint
*as a percentage of gross state domestic product (GSDP)

When asked about the saturation of 20 ml glass containing 10 ml water, it is rather difficult for anyone to be wrong. Some would say that the glass is half full. Others would say that it is half empty. But can those who pocket millions for their opinions on financial markets get as lucky? Well it seems that Goldman Sachs has been using such tactics. The result being that few opinions of the financial behemoth always prove themselves to be right! An article in Business insider quotes some of Goldman Sachs most reputed investment advisors. Ironically their opinions are way too divided on the trend foreseen in financial markets. In fact if a client of Goldman Sachs is to follow all these advices, it would be far easier to toss a coin for making decisions. Since the opinions range from being bearish to uber bullish, there is hardly any chance of going wrong. Thus little wonder that Goldman Sachs has hardly ever been wrong despite the erratic market movements. Its clients though are not too impressed even with its track record.

In his theory of evolution Charles Darwin had used the phrase "survival of the fittest" to describe the process of natural selection. This phrase has held well in the world of investments as well. For the big US companies have emerged stronger out of the recession that has killed or put most of the smaller companies in a dire state. The companies had embarked on strict cost cutting measures that included downsizing their workforces at the peak of the recession. This has put them on a firmer financial footing and as a result, they are more productive and more profitable. Add to this the fact that their burden of debt has also considerably come down. Having taken a big hit in their businesses during the crisis period, these companies have also adopted an increasingly cautious approach when it comes to big ticket investments and capital expenditure. As a result, these companies are poised to take off on the next phase of growth.

Increase in property prices has impacted volumes in the real estate market. As per data released by the Census Directorate, approximately 37 lakh houses are lying vacant in Maharashtra. The Mumbai property market, which is considered to be the most promising market, is also witnessing a dearth of buyers with 4.8 lakh houses lying vacant. Lower occupancy ratio signifies that the property market is probably overheated. But higher vacancy must be seen in the broader context. Some of these vacant houses belong to investors who do not want to lease them out. This increases the vacancy factor. Further, locked houses were also deemed vacant by the census authority. Again the housing data included residences as well as other dwellings like shops, offices, factories, workshops etc. Thus, the high vacancy factor should not be taken at face value. But it is true that the number of houses sold have declined over the last few years due to increasing prices. And unless prices cool down to more realistic levels the vacancy factor might deteriorate further.

One of the factors that made the US a force to reckon with in the last century was innovation and manufacturing prowess. But the global financial crisis and recession thereafter hampered growth considerably and led to a sharp rise in unemployment. That said, it appears that manufacturing in America seems to be picking up pace once again. This has been on the basis of three trends observed. For starters, the cost advantage gap between the US and emerging markets is narrowing. In a bid to keep costs under control, American firms have been increasingly outsourcing factory work overseas. However, as growth in emerging countries has been so robust, demand for higher wages has also been on the rise. Wages in the US are still higher than what they are in the emerging countries. But the gap seems to have narrowed. To add to that, firm oil prices have made shipping costs expensive. Thus, firms are once again focusing on manufacturing back home. Furthermore, a weakening dollar has also made the US goods more attractive to foreign buyers.

What is the key difference between public spaces such as a park or a shopping mall? While both are accessible to the general public, there tends to be a bifurcation of public depending on their economic background. An article in a leading business daily discusses India's transition into a market-based economy- one in which decisions regarding investment, production and distribution are based on supply and demand. In other words, prices are determined by supply and demand.

In order to reduce the burden on itself, the government over the long term has invited private players to enter the space of public services - education, security and healthcare to name a few. Overtime, the cost of acquiring such services has gone up. And with the same happening, the burden on the weaker section of the economy has increased. The author of the article has compared India to the developed world. But the key difference here is that the discussion for the latter has been done in hindsight. Considering that India is relatively still in the initial phase of a market based society, certain measures can be taken to alleviate the issues from a long term perspective.

The Indian stock markets opened the week in the red. At the time of writing, the BSE Sensex was down by 218 points (1.2%). Among sectoral indices, pharma stocks were the only stocks that could manage some gains. Red marks were seen across Asian stock markets with South Korea and Japan leading the losses.

 Investing mantra
"You must be patient...good ideas tend to be clustered together, and may not come at even time intervals...when you don't find anything for a while it can be irritating." - Warren Buffett

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    2 Responses to "Are financial theories useless & dangerous?"


    Apr 10, 2012

    Yes certianly financial theories are useless and dagerous.


    Jeevan Shetty

    Apr 9, 2012

    Value engineering no doubt is simple, reliable and easy to understand. Consequence of error normally will not lead to disastrous consequence. However often value engineering overlook one important aspect of 'pedigree'. It's very important who is controlling the business and what is the historical background and past behavior of the individual or group controlling the enterprise. Very often the goals and the objectives of the promoters are not exactly the same as of minority share holders. Example during the sixties and seventies many of the family controlled companies managed to keep their book profits low. Some even showed losses. Still no body wanted to sell their business. It no secret that why a promoter should continue to run a loss making enterprise. This behavior changed after the pioneering business model shown by promoters of Infosys.
    To conclude value engineering should be complimented by other factors like business risks from environment, health and safety for long term success of the business.

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