Is investing an art or a science?
F-5E Tiger II. Source: Wikipedia
This seems a straightforward question. Portfolios are matters of math, return, cash flow, and valuation. But putting them together is complicated. It’s not just how different investments behave in different economic environments, it’s also a matter of being able to hold on when times look tough. Different investors have different needs – and different approaches to an uncertain future. Understanding how to structure our holdings so we don’t need to worry – about them or about the future – is not a simple task. But new tools and a new understanding of how people make decisions may help.
Notably, there’s a parallel to investment management from the aerospace industry. Fifty years ago the US Air Force had decreed that air-to-air combat was all but dead. The dogfights of World War I and World War II were matters of romance and history. What mattered for air power was strategic bombing and technology. Air-to-air and surface-to-air missiles would make fighter tactics obsolete. And dogfights had always been considered more art than science – with too many variables and too much uncertainty to be reduced to engineering and equations.
But one pilot pushed back. John Boyd was too young to fly in World War II and never engaged a Russian MiG in Korea, but he was a natural when it came to dogfighting. He had an intuitive understanding of how his aircraft would and could behave in various situations. He became an instructor at the Air Force’s Fighter Weapons School at Nellis Air Force Base and wrote the definitive manual on fighter tactics.
But Boyd wasn’t satisfied with the “dogfighting-as-an-art” approach to aerial combat. Airplanes are matters of engineering: propulsion and lift and design. There should be a way to quantify how an airframe can perform in different flight circumstances, then compare one airplane with another. He obsessed over this problem until – while working on an engineering degree – he came up with a breakthrough idea: energy-manueverabilty theory. The theory is both simple and elegant. The performance (P) of an aircraft can be summarized by the following formula:
where V=velocity, T=thrust, D=drag, and W=weight.
By evaluating Ps over the entire flight envelope, Boyd was able to find exactly when and how a fighter would perform at its best against enemy aircraft. He created a revolution in aircraft design, and the major contractors used this formula to design the F-15 and F-16. Boyd also used the formula to sharply criticize the F-111, noting that it underperformed its Soviet counterpart in every possible flight configuration. The combat performance of the F-111 in Vietnam would tragically prove Boyd correct. Boyd made other significant contributions, so many that some say he fundamentally changed the art of war.
Investment management today is in a state similar to aircraft design in the 1950s. Now, as then, powerful new technologies have made the old way of doing things obsolete. Now, as then, entrenched industry players keep using legacy approaches, because it’s just too inconvenient or expensive to convert. Now, as then, advances in our understanding of human behavior – especially under stress – must be part of the design process.
Risk and return graph of possible portfolios. Source: Wikipedia.
Some of these new investment tools are based on technology: AI, Big Data, mobile computing, and blockchain. Some are regulatory: SEC rules on ETF registration, fiduciary duties, and new tax and estate structures. And some are improvements in our understanding of how investors behave: prospect theory, A/B testing, and communications. Together, these advances are just as revolutionary as jet engines, directed thrust, and fly-by-wire controls.
Investing is practiced as an art, but it’s really a science: the science of allocating capital when we don’t know the future. It’s possible to quantify a risk and return envelope under various constraints. The challenge is applying our knowledge in the right way at the right time with the right investors.
Investing is a science, but working with people will always be an art.