A Wall Streeter Asks: How Did We Get it So Wrong?

Here is what John Mauldin says to answer the question. This is an extract from a blog entry at Barry Ritholtz's The Big Picture website. I find this to be a straightforward an analysis of how the Wall Street big shots got it all wrong. I've put in bold key bits:

So how did we get it so wrong? How did we get here? Let’s go back to first principles: Ideas have consequences. And bad ideas tend to have bad consequences. We’ve taught two generations of financial managers theories that were patently absurd. Rob Arnott is going to be here later with us for the panel discussion. Rob recalls standing in front of 200 academics, professors in schools that teach economics. He asked them, “How many of you believe in the efficient market hypothesis?” Something like two or three raised their hands. “How many of you teach it?” All of them raised their hands.

We have been teaching generations of MBA students economic garbage. Gaussian curves and things you could model. The classic line is from Ibbitson, is a brilliant professor and a brilliant mind, who said economics is a science. No it’s not. It’s barely an art form. It’s voodoo. That’s what we practice. We look at the entrails of the Wall Street Journal and try to predict the future. Sometimes it’s
about as bloody as sheep entrails. CAPM… poor Harry Markowitz’s Modern Portfolio Theory got so twisted beyond recognition. I remember being with Harry Markowitz. I gave a speech at a big hedge fund conference about five years ago, talking about why Modern Portfolio Theory was not going to work. The next year it was the 50th anniversary of Modern Portfolio Theory, and they brought Harry out to speak. He of course talked about why it was. I remember meeting him in the hall of this big hotel. And I asked him a couple of questions; I forget what they were because he so staggered me with, “Oh, you missed the
whole concept of correlation and assets. Correlations change.”

And he started drawing quadratic equations in the air. But because I was standing in front of him, he was
drawing them backwards so I could see them. I mean, this guy is absolutely brilliant. But he’s right, you should have a diversified portfolio of noncorrelated assets; but as John was showing yesterday, correlations in a crisis all go to one.

What money managers did was to create models that said, “If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes — see what happens? You get long-term positive results.”

And they would project that into the future. But they didn’t project crises, when correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?

Well, we can go back to the 19th century and see it. But we created a trend from 1944 to 2000 that said we were going up, and we trained a generation to believe they could model, and they did it. They modeled garbage, and now we’ve wiped out a generation of retirement income. I could go on and on, but it’s nonsense.