'Animal spirits' vs the efficient market hypothesis 13 JULY 2017 | ALEX WAITE

'Animal spirits' vs the efficient market hypothesis

13 JULY 2017 | ALEX WAITE

Alex Waite asks whether actuaries are evolving to remain relevant in their economic predictions

When I was at school, I wanted to know how the world worked; how planes could fly; and how the international economy functioned. Long before my actuarial exams, I wondered about hyperinflation in the 1970s and the impact of the stock exchange ‘Big Bang’ in 1986. More recently, I’ve been puzzled by how the market seems to get things so wrong: like the millennium ‘dot-com’ bubble or, as put so succinctly by Her Majesty the Queen to the London School of Economics: “Why did no one see [the financial crisis] coming?” If the market can’t be trusted to get things right, can actuaries?

I was fascinated to hear of the revolt of economics students in May 2014. Quoting the Guardian: “Students, who have formed protest groups in universities from Britain to Brazil, say research and teaching in economics is too narrowly focused. They want courses to include analysis of the financial crash, that so many economists failed to see coming, and say the discipline has become divorced from the real world.” This isn’t just young protesters either; John Kay wrote a piece in the Financial Times entitled: “Angry economics students are naïve – and mostly right”. 

As actuaries, we claim to “make financial sense of the future”. In particular, users of actuarial projections expect us to understand economic thinking and modelling. My challenge is: “Are we doing enough to keep up with these evolving subjects?” We could be doing a lot more to ensure we are leading the way in this innovative field, so that actuaries of the future inherit a profession with a reputation for sound economic projections.

It all starts with the efficient market hypothesis, which underpins the grand theory known as capital asset pricing model (CAPM). Under this model, the market is king; based on a few simple assumptions, including perfect information, frictionless transactions and consistency over time horizons, the market price is the starting point for every assessment. Based on CAPM, and a few other assumptions, the implied price of everything can be mapped out for the next 80 years!

Magically, we have ‘the value’ of a pension scheme (based on gilt yields) or the reserve for a periodical payment order (PPO) claim (based on the Ogden rate). For our chosen investment strategy, the economic scenario generator has given us the miraculous ‘funnel of doubt’ – who are we to question it?

Animal spirits

If only markets were so reliable; driven as they are by Keynes’ ‘animal spirits’. Let’s take a closer look at whether those ‘simple assumptions’ hold in the real world. For starters, no investor has perfect information. Big data techniques scrape information from the internet, to help market participants outsmart competitors; transactions always incur a cost; and, while investment managers seem to look at the short term, many are actually looking for long-term returns. As Warren Buffett puts it: “Prices are very different to intrinsic values… in the stock market you do not base your decisions on what the market is doing, but on what you think is rational.”

There is plenty of work going on among professional economists and academia to understand the increasingly interconnected financial world. Indeed, the IFoA has hosted events on complexity, resources and the environment. However, a lot of our thinking is done in smaller enclaves, such as actuarial firms or investment houses. Surely the profession has a role in bringing together best-practice ideas and helping evolve economic projection methodologies for the public good? 

What can be done?

The IFoA has set up a small group working with an independent academic researcher, Dr Iain Clacher, to investigate current practice in this field. The Economic Modelling Group will ask actuaries how they currently use economic theory, and tease out how we could do better. We encourage you to participate. 

Having qualified as an actuary in the 1990s, I recently embarked upon the profession’s newest exam, the CERA qualification. I was staggered at the advances in mathematical modelling and economic theory that are now routinely taught to young actuaries and underpin both Solvency II and the Pension Regulator’s integrated risk management approach. Today, I still struggle to explain the ‘Trump bounce’, or predict how climate change will affect future world economic development, but I hope that by coming together as a profession we can truly help make financial sense of the future.

For group details, email: research@actuaries.org.uk

Alex Waite is an actuary at LCP and a member of the Economic Modelling Group