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Finance academies predominantly remain loyal to the theoretical world

For over 40 years now, the world of academic finance has operated in parallel to what actually takes place within financial markets and institutions. There have been circumstances in which efforts were made to understand why certain actions were taken by executives and what they need to do in order to improve how they operate, but on the whole it seems that publishing elegant theories, supported by complex mathematical and statistical formulas, are preferred to the development of ideas that can in fact be of benefit to financial executives.

Some of the most important financial contributions from the leading finance academies have, however, come under severe criticism in the past couple of years. Untested models were blindly instituted within some of the world’s most respected financial institutions and the results have been devastating.

While the major economies might be slowly coming out of economic stagnation, the world of academic finance is just beginning to feel the full force of the crisis. Many believe that these institutions should also shoulder some of the responsibility for the current crisis. They developed highly theoretical models and presented them as fit for purpose. In case you doubt that, just search to see how many quantitative/mathematical finance courses have been developed in recent years. You can count on one hand the models taught in these institutions that can actually, and reliably, be applied in practice.

Of course, financial institutions themselves are also not completely innocent either. Many of the models were developed by the banks themselves. More importantly, they naively assumed that the models, so long as they were presented in an elegant fashion, should work. Well, we now know that they did not.

However, the main issue is not the few attempts at developing pricing models that are questionable, and have been proven inaccurate, including simple models for quantifying risk. At the very least, they can be complimented for making the effort to develop these models. The main problem remains that most finance academics refuse to work on articles and research that can in fact be of use to practitioners.

We have libraries full of articles that use aggregated data, with flawed methodologies, to arrive at conclusions that are quite visibly questionable to anyone who asks simple practical questions.

That is indeed what my co-author and I have done in our latest article in the Economists’ Hubris series of articles, entitled Economists’ Hubris – the Case of Award Winning Finance Literature. We have tried to give a reality check to award winning articles in the Journal of Finance and the Journal of Financial Economics, the two leading journals in this discipline. We specifically chose those articles that won prizes in 2008 and 2009 in order to see whether the recent public backlash against the far too theoretical works that academic institutions undertake and publish has had any effect in ensuring that future works take on a more practical focus.

Sadly, we find that the insistence that referees place on citations of previously published papers that were based on highly questionable theoretical workings results in situations in which researchers find it hard to develop any new, and more importantly practically focused, ideas. For example, anyone who has ever worked in financial markets knows that the Efficient Market Hypothesis only exists in the minds of academics, and yet it has to be unquestionably accepted by future researchers as gospel. And, if anyone thought that behavioral finance researchers are adding a bit of reality to this world, they are highly mistaken. They have just taken one highly questionable theoretical model and created their own version. A couple of the articles examined in our paper do try to question the validity of EMH, for example, which is encouraging, but they are also found to be of limited practical use.

Unlike most genuine sciences, where students can use a good portion of what they learn at university within their jobs, finance courses have simply become tests of aptitude. If you obtain an MSc in Financial Engineering it means that you are intelligent enough to understand what you will be asked to do in your work. It certainly does not mean you will be able to apply anything you learn at university in your job.

It is similar to the logic that the old London-based merchant bankers used to apply when hiring students who graduated from Oxford and Cambridge Universities, even graduates in subjects such as Classic History or Languages. These students had no idea how financial markets really operated, but since they proved they were intelligent enough to graduate from these universities they were probably able to quickly learn about practical finance and get on with their jobs. And, overall, they didn’t do too bad a job either.

Sadly, that is now the case with finance graduates. All financial institutions, or consultancies, have to retrain their recruits in practical finance from scratch. Consequently, all they are looking for in graduate recruits are people who have proven themselves to be fast learners. Just ask yourself, how much of what you learned in Corporate Finance at university can you apply when working in the Corporate Finance Department of an Investment Bank, and whether it would have made a slight bit of difference if you had indeed studied classic history at university.

Even worse, when you obtain a degree in mathematical finance the risks to the system are greater, since your teachers forget to mention that the models should come with a long list of warnings attached. Students must be warned that while these models are elegant, they are not by any means scientific. The result is the hubris that we all witnessed prior to and during the recent crisis.

It is time that academic institutions work in closer collaboration with financial institutions to develop future executives that actually understand practical finance before they start work. They also need to involve practitioners in refereeing papers to ensure that they can actually be used by those who need to apply them. If that happens, academics will spend less time developing complex models to test useless data, and start thinking about developing ideas that actually make sense to anyone but the theorists who referee finance journals. We, ourselves, have established partnership with two institutions, Cass Business School and NYU-Poly, who are as determined to train their students in practical finance as we are. Sadly, the list of such institutions is very small.

The current crisis has given us a unique opportunity to discard 40 years of theoretical finance and to start developing more practically focused finance courses and research. All good industries know when it is time to discard disproven theories and to work on developing new ones. Academic finance is also at this point now. We hope that leading journals and institutions also take on this challenge.

Read our latest article: Economists’ Hubris – the Case of Award Winning Finance Literature. You might need to register, but it is free. We welcome all comments.

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