Rethinking the finance curriculum

Emerging in the wake of the Rethinking Economics movement is Rethinking Finance, and it looks as if Rethinking Finance is going to place some emphasis on the finance curriculum, just as Rethinking Economics , as a student organisation,  has.  @NeilLancastle, one of the organisers of Rethinking Economics asked me for my views on the finance curriculum, with reference to a review published by the CFA Institute Research Foundation.

As a lecturer in finance (derivative markets and pricing to actuarial undergraduates and MSc students) two things are in my mind.  Firstly students have little interest in and less conception of the nature of money.  I think this is peculiar given they have made a commitment to working in finance which is concerned, principally, with money (OED 7: finance (n); The management of money, esp. public money; the science which concerns itself with the levying and application of revenue in a state, corporation, etc.).

More relevant to the students I work with, who approach finance mathematically, there is virtually no ability to critically reflect on what they are told.  This was emphasised a few months ago with our MSc cohort in Quantitative Financial Risk Management, which is notorious for testing maths graduates with qualitative approaches to risk.  We arrange for the students to address problems set by business, and this year a problem was set by an asset manager and the question related to the value of active fund management.  The students, universally, answered the question on the basis of the guidance and literature that the asset manger provided: they were a series of presentations suitable for a stock pickers' benevolent fund. All the presentations were scholarly weak, but the question the academics, as examiners, had to address was whether it was fair to penalise the students when we do not train them to be critical of published research.  In developing mathematicians, the truth is the truth.

What struck me when comparing the CFA's proposals (p 73) with those from a conference sponsored by the Royal Economic Society reported in 2013 was a similarity.  The RES highlights

There was broad agreement that students need:

• Greater awareness of economic history and current real-world context;
• Better practical data-handling skills;
• Greater ability to communicate economics to non-specialists;
• More understanding of the limitations of modelling and current economic methodology;
• A more pluralistic approach to economics;
• A combination of deductive and inductive reasoning.

where as the CFA

asked sources what subjects they believed should be reinforced in or added to the curriculum. ..., as follows:
• macroeconomics,
• a historical perspective on macroeconomics,
• the history of financial markets and economic history,
• behavioral finance,
• statistics beyond the use of the normal distribution,
• risk management, and
• ethics.

The key overlap seems to me to be in

• a historical perspective [this would lead to] 
• pluralism
• practical tools
• a synthesis of facts with values 

Focusing on the CFA report I noticed a tension captured by the final sentence of this paragraph spanning pp 1-2

Is our “science” merely an idealized rational construction that ignores market realities? If so, exactly what should we be teaching students of finance whose objective is to manage other people’s money? Is an alternative science based on observations available (or in progress)? Or does our current knowledge of economics and finance have to be removed from the realm of science altogether and placed on a par with the social sciences? (my emphasis)

I think what this highlights is a lack of clarity over what is meant by 'science' (in what sense are social sciences removed from the realm of science?).  Because there is this lack of clarity, I think it is difficult how to answer the questions posed.

I don't think this lack of clarity about science is a particular feature of the CFA or finance more generally, I think it is a common problem that makes resolving these sorts of issues hard.

Labelling different disciplines as 'science' or 'not science' and be problematic.  I tend to use the term 'human sciences' to emphasise an equality of status between history (human), economics (social), biology (natural), physics (physical) and statistics (mathematical).  However I do think it is sometimes helpful to use the classical distinctions of episteme, phronesis and techne.  The work-place is often associated with techne, the university, especially in the context of research,  with episteme.  These terms could apply equally well to all disciplines and professional bodies, such as CFA, should be concerned principally with phronesis.

This train of thought might suggest that I think academics do not involve themselves with phronesis, this is not the case.  I feel that academics place too much emphasis on episteme at the expense of helping students in developing phronesis.  This is demonstrated by graduates leaving university with a sense that they know the truth but completely lacking in practical skills.

These comments encapsulate my criticism of the first part of the CFA report.  The second part of the report focuses on six aspects of investment management, namely

• diversification,
• optimization-diversification formalized,
• the CAPM and similar models,
• the efficient market hypothesis,
• risk measurement and risk management, and
• crises.

What strikes me is the implication of the report (all be it corrected in a footnote) that diversification started with Markowitz, on this basis optimization is mean-variance portfolio selection that, in synthesis with neo-classical economics,  leads to CAPM.  What this account (and presumably the CFA syllabus) lacks is a historical perspective.  Diversification existed long before Markowitz and the success of mean-variance portfolio selection was a much because of its mathematical tractability, rather than its 'financial' sense.  Given that the CFA is keen to promote behavioural finance, a key object of behavioural finance are S-shaped utility functions, it is therefore worth noting that these were first identified in 1948 in the collaboration of an economist (Milton Friedman) and a statistician (Jimmy Savage).  The apparent omission of this work from the CFA syllabus, probably because of the problems of optimising S-shaped utility curves is  "massively difficult", highlights the main problem with the syllabus: it tells a simple story rather than preparing candidates for practice.

A similar issue exists with risk management.  Again this is an old practice that has been incorporated in to actuarial science for hundreds of years but is presented as being a modern science.

My work sees EMH as being an expression of justice in exchange, so EHM can be retained even if the focus of finance switches from individual profit maximisation in a competitive arena to reciprocity in support of social cohesion.  This work has initiated a switch in my own research from focussing on stochastic control to exploring complex network theory in order to better understand crises.

What links all these six themes is the importance of a historical context.  I often remark that for financiaers to justify fat fees they need to convey the impression that they are addressing novel problems.  I think if you consider the history of finance you soon come to realise that the problems and technologies are persistent, it is the culture that changes.

Section 3 of the CFA report moves on to consider the teaching of finance in reference to the topics discussed.  In section 4 it asks what is missing from the current curriculum and comes up with the seven topics listed earlier.

The first suggestion is the need for more macroeconomics.  But what does this mean?  Macroeconomics is usually concerned with aggregate parameters - GDP, unemployment, inflation, savings and investment rates, etc. -and the simple relationships between these parameters.  The standard models they work with - Aggregate Demand - Aggregate Supply, Investment Saving–Liquidity Preference Money Supply - don't seem that useful to financiers.  What I think is more useful is the presentation of money (and finance) as an integral part of a highly connected economic system; the relations between interest rates, exchange rates, prices, demand, supply, confidence, uncertainty.
This observation ties into the second suggestion: the need to take a historical perspective on macro-economics.  This should highlight the relationships I mention.

The third suggestion is, to my mind, critical for the CFA syllabus: The History of Finance/Financial Markets.  The report lists a number of texts, I would add Geoffrey Poitras' The Early History of Financial Economics, 1478-1776: From Commercial Arithmetic to Life Annuities and Joint Stocks.  I would also support strongly William Goetzmann's comments that

Studying the how and why of financial institutions, markets and instruments forces us to understand modern finance in the broader context of human lives. It provides a framework for understanding how finance can make the world better and what kinds of possibilities and problems can emerge. 

 I think this: disseminating the role finance has played in stimulating the development of science and democracy; should be a core priority of the CFA, as the principle professional body.  This is an emphatic statement but having met Richard Seaford recently, who argues that the origins of Greek philosophy are in money, combined with my knowledge of the impact of finance on European thought in the thirteenth and seventeenth century, I think this is an important story untold, to the detriment of financiers and their practice.

I have been told that there is a trend in business schools (and the like) to shift from focusing on a narrow definition of finance to evolving into research/teaching establishments that place finance at the centre of an multi-disciplinary constellation.  I understand this is the ethos at Copenhagen and Vienna.  In this setting it is hard to see how behavioural finance does not become integral to finance as a whole.

From this starting point, Behavioural Finance follows as well as the Ethics issue.  I must admit that I feel the CFA is weak on ethics, its Code of Conduct appears to me nothing more than "don't break the law".  Ethics is much more than this.  The Governor of the Bank of England recently highlighted the issue in a speech where it is pointed out that , in the past

 Bank leaders created cultures around a simple principle: if it’s legal and others are doing it, we should do it too if it makes money. It didn’t matter if it  as the right thing to do for the customer, community or country

 The rational approach to ethics is to place it in a cultural context, this is only really feasible if the theory of finance is placed in a cultural context.

Finally, since 2007 I have perceived a convergence of asset and risk management practices, locally this is characterised by Standard Life's GARS fund.  My suggestion to the CFA is to re-structure "Modern Portfolio Theory" as "Risk Management" with Markowitz, and its successors, being one approach where risk is managed by minimising variance of returns.

In summary, my syllabus structure would be

1. The nature of money (macroeconomics and more)
2. The purpose of finance (history and ethics)
3. The practice of finance (behavioural, risk and asset management)
4. Tools and techniques (optimisation, statistics)

and my closing comment is that it would take at least seven years for a apprentice Merchant Adventurer or Mercer to become a freeman in the sixteenth century.  That is seven years of on-the-job training.  Students today believe they are qualified after a degree and maybe 3 years preparing for CFA I, II, III.  Actuaries can expect to be fully qualified after one of our 4-year degrees and 2-3 years on the job training.  I am not convinced that the contemporary training is as good as the medieval training (in relation to contemporary complexities).  I also believe, as does Mark Carney, that banking needs to be professionalised by "building a sense of vocation and responsibility" like the law, medicine, accounting and insurance.  I think the CFA should take a central role in advocating this.