If I were the dean of a college I would put the economics department in with the history department, or possibly the psychology department. Just the thought of associating the term “science” with economics is very misleading to all students and layman trying to understand economics and investment theory and downright insulting to scientists.
The problem lies in the actual outcome of economic results as compared to the predictive theory. Just ask the architects of Long Term Capital Management (LTCM). This hedge fund blew up in 1998, yet at the helm were two Nobel Memorial Prize winners in Economic Sciences (see the misuse of the term science), Myron Scholes and Robert Merton. These award wining economic “Scientists” were the best of the best (said sarcastically) that the industry had to offer. Ironically their tag line from a 1990’s brochure was LTCM “The Financial Technology Company”. The irony lies in the use of the word “Technology”, because if that is the best technology that we have, we would never have invented the computer or landed a man on space.
Their company blew up because they treated economics as if it were a technology or science. LTCM based their highly leveraged trading strategy on a normal distribution, the “Bell Curve”. That works great for things like the height of the human population and exam scores. The leaders of LTCM said that what they experienced was something like a six sigma (standard deviations) event, or an event that should only happen once in every six million years. Yet this “extreme” trading event happened in less than 10 years from the founding of the company.
Which leads me to a great book that is more in line with what I consider to be correct economic thinking. The book “The Black Swan: The Impact of the Highly Improbable” by Nassim Taleb, basically states that the rare event such as the 100 year flood occurs every 5 or so years. The term is “fat tails”. A normal distribution (bell curve) shows that as extremes are reached, the number of occurrences becomes more rare. An example would be the height of the human population. There are a lot of men with heights between 5’6 and 6′ 2″, but very few men over 7′ or under 4′. This is a normal distribution. But Taleb argues that investment theory doesn’t adhere to a normal distribution with skinny tails, but reality is much less statistically predictable and produces an abnormal distribution of events with a high occurrence of extreme events at either end of the spectrum, hence the term “fat tails”.
LTCM entire theory, and even their Nobel Prize was based upon this normal distribution and a reversion to the mean. Kind of like a rubber band that even though it might be stretched, will come back to it’s unstretched size. What LTCM didn’t count on was the rubber band breaking. Their trading model broke, or more realistically was never good in the first place.
This leads me to one of the most valuable examples I have read which clearly shows that history trumps all when it comes to even considering economics a science. Now the exact details of this story are a little murky, so I know that I am likely to get some of the details slightly wrong, but errors in the details will not detract from the morals of the story. Feel free to correct me in the comments section. I believe I read this example in one of Marc Faber’s books, possibly “Tomorrow’s Gold”.
The story goes as follows. If the wealth of the Medici family (Wealthy Italian family in the 1500’s) were to grown at 5% per years, their wealth in terms of gold today, would be a physical gold amount greater than the entire weight or size of the world. As comparison, the real amount off all the gold in the world is only a cube about 20 meters on a side. The other analogy made, was if I were to have had one dollar in the year 1,000 and it were to compound at 5% a year until present, I would owns the entire productive capacity of the world several times over.
Now when I present these concepts to people and ask them “What is the moral of the story”, invariably most will say “It proves that the compounding of money is very powerful”. While this is a true statement, it misses the real moral of the story. You see the entire amount of gold in the world is only a 20 meter cube, not the size of the entire planet, and no one individual owns the world several times over simply because their family invested one dollar many generations ago and earned a paltry 5%. The real moral of the story is that nobody over very long periods of time have ever earned a 5% return. Through a myriad of extreme events capital has been destroyed, and destruction of capital is more likely than preservation and growth.
While it seems that only a fool would loose their money, if you look at history you can see that history can have quite a destructive effect on one’s wealth. First off you have taxes. Most high wealth / income individuals will pay 50% of their income in taxes. Then there is the loss of money through inflation, which is really just the debasement of currency, another form of tax. Then throughout history there have been the confiscation of private property by socialist, communist countries. Not to mention if you were a GM bond holder, entitled to first dibs in a bankruptcy proceeding, the US Government forced you to take a loss and gave your money to UAW. Then you have wars, where a foreign country might decide it wants your stuff. Or John Corizone of MF Global might just “Lose” you money. And this is all before you even have a chance to make a mistake yourself with simple stuff like making a bad investment or simple mismanagement of money. The moral of the story can be nicely summarized by Warrent Buffett’s first two rules of investing. 1) Don’t loose your capital and 2) Refer to Rule #1.
It is a travesty to even use the word Science and Economics in the same sentence. If our scientific community were to have the same results as the former leaders of LTCM, who were awarded The Nobel Prize for Economic Sciences, then our computers would only work 80% of the time. The other 20% of the time, they would do completely random things. Maybe blow up. Maybe they would make coffee, or possibly teleport you to mars. If NASA had the same result as most Economists, rockets would end of on the wrong planets, maybe never get off the launch pad, or possibly return to earth with astronauts missing. It is truly appropriate to say that economists give even astrologers a bad name.
My break down of economic theory might be 20% science, 40% history, 30% psychology and 10%…. ?. Well I haven’t figured that out yet.