Heterodox Investment Theory

Finance claims that statistics predict in investing. Because finance is emerged in statistics, we need the critical thinking of the humanities to investigate the predictability of statistics. The history of finance will show other paradigms of finance, and how finance became a part of economics. The philosophy of statistics will be put in discussion with its counterpart of the philosophy of uncertainty, which implies unpredictability. The analysis of the rhetoric of investment theory is another insightful way to understand its discourse, its metaphors, and its stories. Culture provides another domain of critical analysis of investment theory. The critical analysis releases energy to the challenge of a heterodox finance which consists of alternative theories of investing, the employment of virtue and value ethics, and practical wisdom.

The study of the history of investment theory shows the merging of finance, statistics, predictability, and economics into the current investment theory. An analysis of the history of a field clarifies its current paradigms and contrasts them with the previous and the competing paradigms. The notion that investment theory is a young science since the 1960s is flawed. Finance as relevant for investment theory has existed since the thirteenth century. The legitimization in the 1860s of investing in stocks, which until the nineteenth century were associated with gambling, results in efficient market theories. Investment theory in France in the nineteenth century and in the United States in the first half of the twentieth century is full of treasures, illustrated by the work of Regnault, Bachelier, Fisher, Cowles, Macaulay, Williamson, and many others.

The heterodox investment theories do not pretend to predict profitably and aim at explanation or modelling of financial markets. The ideological criticism of modern finance, political finance, uses elements of behavioural and bubble criticisms, and combines them with the criticism on free markets in general. Mandelbrot’s fractal finance provides within the rational mathematical tradition an alternative statistical theory, which models seemingly predictive patterns in financial markets, wild volatility, and bubbles. The bubble theory explains how bubbles in (financial) markets arise. Behavioural finance is insightful and helps to reflect on decision making, and explains behaviour of market participants. The bottom-up approach of evolutionary finance yields an interesting alternative to the top-down approach of modern investment theory. Concerning the depth of the rival theories of finance, they all have substantial backing and empirical proofs which can compete scientifically with modern investment theory.

The epistemological beliefs of investment theory are rooted in the philosophy of probability. Markowitz’s arguments for using statistics in investment theory stem from Savage’s theory of subjective probabilities. The CAPM and the empirical investment theory are founded on the idea of objective probabilities. Markowitz has put investment theory in the category of Knightian risk, instead of in the category of Knightian uncertainty. The common denominator between the views of Knight, Keynes, Von Mises, McCloskey, and Taleb is that stochastical predictability is a rare case for economic phenomena, so Knightian uncertainty is relevant for economics. A thought experiment demonstrates that a rational financial firm would never market a synthetic stock with a specified risk and return like investment theory assumes, because it cannot be hedged risk-free.

The analysis of the rhetoric of investment theory is grounded on the approach of the rhetoric of economics by McCloskey, who considers economics as a product of the modernistic scientific culture of logical positivism with an emphasis on prediction, mathematics, and statistics. The main metaphor in Markowitz’s investment theory is the claim that investment management is mathematical statistics, in which investment returns are a probability distribution. The second metaphor in Markowitz’s theory is the machine, recognized by the aspiration to efficiency. The dominant metaphor in the CAPM is the equilibrium. The second important metaphor is again the machine metaphor of informational efficiency. Because the epistemology of investing is not suited for predicting, McCloskey proposes virtue ethics.

Klamer’s approach of the culture of economics is relevant and applicable to investing, because culture is an extension of rhetoric and relates to uncertainty. Uncertainty, a feeling of anxiety, is handled by culture. With culture, Klamer focusses on substantial instead of instrumental rationality, and advocates value ethics. In Klamer’s approach values and conversations are central. The values of a culture are not evident and therefore have to be interpreted. Emerging from my personal observations, the interviews, the literature, and the book, the prime shared values of Dutch institutional investors are wealth, optimism, and rationalism. The archetypical conversations of investors are about ‘The market and the economy,’ ‘Talk by the model,’ ‘Money must be put to work,’ and ‘Doubt and reassurance.’

The investigation of stochastical predictability in investment theory is relevant for science, but also for investors, the financial sector, policymakers, bankers, and the society at large, because treating unpredictability as predictability can and did harm the economy and people’s wealth. The new proposed rhetoric, discourse, of heterodox finance is that investing takes place under Knightian uncertainty, which makes statistics supportive rather than dominant in decision making. So, investment theory should become more a moral science and less an engineering one: it is about judgments, combining virtue and value ethics with historical and theoretical insights, also from alternative investment theories, which can enrich mainstream investment theory and guide practice.