I believe there are two main reasons why Wall Street screws it up from time to time, costing investors billions of dollars. The first reason is that they treat finance as physics, meaning they think finance is a science, expecting the past to predict the future and unforeseen outcomes not to occur.
The other reason Wall Street won’t stop blowing up at regular intervals is they assume all of the decisions made in the financial markets are completely rational at all times.
Tolerance for risk
Almost three centuries ago, mathematicians Nicolaus and Daniel Bernoulli came up with a theory. What it said was that people will choose the outcome that provides the maximum benefit for their situation, taking into account their tolerance for risk, and that their decisions are based on the information they have. This expected utility theory was strengthened by books written by several academics in the last century which concluded that a rational person’s decisions are always completely rational.
A half a century ago, economist Harry Markowitz came up with something called modern portfolio theory, which said it was possible to model and compare investments and find the optimum mix of assets at a prescribed level of risk. This led to the capital asset pricing model and has been followed by a flood of financial formulas. Wall Street believed that by creating better financial math models they could create above-average returns forever. It didn’t always work, because people weren’t always rational and didn’t always try to maximize utility.
The knowledge that people’s decisions contain both rational and emotional elements has been known for 250 years (while the Bernoullis were creating utility theory, economist Adam Smith was writing that emotions affect financial decisions), and the research amassed over the last 30 years has convinced even the biggest doubters that people’s decisions are seldom completely rational. Wall Street has been forced to talk about the behavioral factor because of the repeated failures of their computerized math formulas.
The problem is if Wall Street accepts that all of their financial models are flawed because human behavior is an unpredictable variable–meaning that the rational decision will not always be made–
then Wall Street would be forced be admit that they can do little more than guess about the future.
But one doesn’t pay millions of dollars in annual advisory fees for “guesses.” And this is why the role of annuities will increase in the years to come as consumers move to a retirement vehicle based on guarantees and realize they do not want to base their retirement future on the vagaries of Wall Street.