Thursday, 24th May 2018
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John Smiles

Qualified Financial Advisor

Models and Reality

Without thinking about it, we make a lot of decisions about the world around us based on models that are only approximations of reality. For example, if you check the weather forecast before you leave home, you are relying on many imperfect assumptions in a meteorological forecasting model. This and other models can be helpful to an extent, but anyone who has been caught by an unexpected rain shower will know that models have their limits.

Professional investors use models to gain insights that help them make their investment decisions. But markets, like the weather, cannot be fully explained by a model that only approximates reality.

Much research is done in an attempt to improve financial models and debate often occurs over which model is “better”. These debates are unlikely to be fruitful; you cannot judge the usefulness of a model unless you also consider the user of the model and its application.

For example, a simple model of the earth describes its shape as a perfect sphere. It is useful for teachers explaining the solar system or manufacturers of globes. But an explorer using this model to circumnavigate the world might be surprised when first encountering a mountain range that is not a part of the simple sphere.

Investors should pay similar attention to the application of models. For investors in public markets, the efficient market hypothesis is a model stating that asset prices reflect all available information. This model helps inform investors that they can rely on prices and that it is not worth trying to outguess prices that are collectively set in real time by millions of investors around the world. This insight is confirmed by numerous studies on the performance of traditional active investment managers. That is not to say that having this insight protects investors from making mistakes; close attention must still be paid to any practical application of it.

When evaluating different investment approaches, private investors should try to understand the manager’s ability to effectively test and implement the ideas they garner from their models.

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