Professors Jeffrey Pfeffer and Robert Sutton  at Stanford University have recently published a book that investment professionals would be wise to read. It presents the case for “Evidence – Based Management” for business executives. While it is directed to CEO’s for corporate guidance, we believe it has application to portfolio management. The basic idea is that one should look at the evidence to see if it supports what they are doing or the philosophy that underlies their actions.
What Inhibits Innovation?
Pfeffer and Sutton point out the difficulty of overcoming ideas that become part of the bedrock belief system of the power elite. The history of medicine provides some excellent examples. Joseph Ellis  in his best seller relates how George Washington went out for a ride on his favorite horse one stormy morning in 1799 and came down with a cold. Since his face was flushed the doctors applied the standard practice of draining blood from his body until his face turned the right color. When it remained flushed they tried it again and again and yes, a fourth time until 5 pints of blood had been drained from his body. Finally, they administered a strong laxative…twice. That did it. He died soon after his color returned to normal. Blood-letting was a time honored procedure that had been practiced for hundreds of years, so no one questioned its use… until 1836 when Dr. Pierre Louis conducted one of the first clinical trials and showed that this practice more often killed than cured the patient. In spite of this evidence, it took another 37 years before the practice of blood-letting stopped.
Did the obvious failure of blood-letting act as a catalyst for innovations in the practice of medicine? Forty years later, in 1876, most physicians still did not wash their hands before an operation or sterilize their surgical equipment. This in spite of the fact that Dr. Lister provided clinical proof that fewer patients died in hospitals that took these precautions, and Louis Pasteur proved the existence of germs that could only be seen under a microscope. In a debate at the first American Centennial Lister debated the head of the American Medical Association, Dr. Gross, who opposed sterilizing his surgical equipment and boasted of wearing the same blood splattered suit for each surgery. Who won the debate? Once again, the evidence was ignored and it was business as usual.
These were not isolated incidences. Thomas Kuhn , a philosophy professor at M.I.T. University offers further evidence of this resistance to change. He notes that the scientific community has seldom been persuaded by facts to shift from one paradigm to another. The views of Copernicus were not generally accepted for a century after his death. A half century after the publication of Principia by Newton, the facts he presented were not generally accepted. Max Plank remarked, “A new truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die.”
What Promotes Innovation?
For hundreds of years evidence has failed to produce change amongst learned men of science. But, as the song from Cabaret says, “Money, money, money makes the world go round.” While Lister was unable to sell his antiseptic to doctors to sterilize their equipment, a salesman suggested they bottle the disinfectant as a mouth wash that promised kissing sweet breath. Have you ever tasted the stuff? Right, but the advertising sold it. Listerine mouthwash made millions of dollars in the next few years and continues to make millions to this day. The Listerine story has been reborn a thousand times as witness the endless commercials we are forced to watch even to see the evening news.
We believe that portfolio management is following the same path as the medical profession 200 years earlier. Innovation is marketing driven not technology driven. Time and again outmoded ideas trump evidence. Innovation in medicine finally reached the tipping point in the 20th century.
If it sells it won’t work. If it works it won’t sell.
Let’s examine the evidence. In the early 1950’s Dr. Harry Markowitz offered a risk- return framework for managing portfolios that fell on deaf ears for over twenty years because it was too complicated and required mathematical skills beyond the level of most market professionals. It was rejected by investment experts who felt threatened by any attempt to quantify the risk they were taking. Academics, including members of his dissertation committee, also rejected the Markowitz theory until this simplification was offered: If there exists a risk-free asset and a market portfolio, it would no longer be necessary to know how every asset co varied with every other asset to measure the risk-return tradeoff proposed by Markowitz. Without proof, a linear relationship between a risk free asset and one risky asset was presented. In equilibrium the risky asset would have to be the market portfolio. Thus, Alpha and Beta were born and a whole new financial services industry called consulting came into being to sell performance measurement based on the Capital Asset Pricing Model (CAPM). Consulting firms could now rank all managers relative to the S&P 500, a flawed surrogate for the market portfolio, and sell this one analysis to hundreds or even thousands of different clients.
Some RIA’s who are using PMPT are James Breach, founder of Toronto based Cougar Global, Randy Long at Sage View Advisors in California and Jim Pupillo in Scottsdale Arizona. Any more of you out there? Let me know.