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Contents lists available at SciVerse ScienceDirect

Critical Perspectives on Accounting

journal homepage: www.elsevier.com/locate/cpa

Why nance theory fails to survive contact with the real

world: A fund manager perspective
Les Coleman *
Department of Finance, The University of Melbourne, Parkville, Victoria 3101, Australia

A R T I C L E I N F O A B S T R A C T

Article history: This paper examines why nancial decision theory nds so little application in the real
Received 28 May 2012 world. A review of the literature identies shortcomings in research methodologies, and
Received in revised form 29 January 2013 summarises evidence that core nance paradigms prove of limited empirical value. The
Accepted 4 February 2013
practitioner perspective is reported based on interviews with 34 fund managers on four
Available online xxx
continents. These conclude that nance theory is of limited relevance to practitioners
because its quantitative approach requires data about the future that are unavailable, and
Keywords:
because it ignores practitioner objectives and skill, and the wealth of qualitative data
Critical
Accountability available to them. The paper concludes that future research should better translate
Finance decision theory practitioner knowledge and practices into improved investment theory.
Investment manager performance 2013 Elsevier Ltd. All rights reserved.
Practitioners

Mots cles:
Critique
Redevabilite, Responsabilite

Keywords:

Palabras clave:
Crtica
Rendicion de cuentas

When a well packaged web of lies has been sold gradually to the masses over generations, the truth will seem utterly
preposterous and its speaker a raving lunatic.
Dresden James (cited by Frankfurter, 2006)
This article contributes to debate over the frontier of future research into investment theory. There is no doubt that
nance researchers during the last fty years have assembled an impressive body of theories and practices. This neoclassical
investment theory now forms the core of nance teaching, and provides a basis for modern investment research and practice.
But it does not stand up well to empirical tests. Thus there is an intriguing paradox in nance: neoclassical investment theory
forms the basis of academics teaching and mainstream nance research; whereas investment practitioners generally prefer
to use alternative techniques.

I appreciate insightful advice on various drafts by Rob Brown, Carsten Murawski, Sean Pinder and participants in a research seminar at the University of
Melbourne. The usual disclaimer applies. I also appreciate advice from the journals editors and referees.
* Tel.: +61 3 8344 3696; fax: +61 3 8344 6914; mobile: +61 413 901085.
E-mail address: les.coleman@unimelb.edu.au.

1045-2354/$ see front matter 2013 Elsevier Ltd. All rights reserved.
http://dx.doi.org/10.1016/j.cpa.2013.02.001

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The strongest evidence that nance theory is unworldly comes from eld studies which show that investors make limited
use of theory in their decisions. For example, Drachter et al. (2007, p. 56) conclude that fund managers eschew theory when
making investment choices which they prefer to base on private information:

The active search for new information is clearly viewed by fund managers as the most promising approach for
performance improvement . . . Discussions with the executive boards of the companies in which they invest are the
most important source of new information.

Admittedly this material is sparse, with interactive studies of investor decision practices limited to Carter and Van Auken
(1990), Drachter et al. (2007), Veit and Cheney (1984), and a few others. Despite the paucity of material (which in itself is
evidence of a signicant research weakness), though, results prove consistent across time and countries.
Other strong, albeit less direct, evidence that practitioners do not apply investment theory comes from the catalogue of
their decision biases, or divergences from theory-based rational behaviour. This is now so extensive as to sustain the
discipline of behavioural nance (Shefrin, 2001).
Just as practitioners dismiss theory, academics conclude that investors destroy value whenever they go near markets.
Typical examples are fund managers who cannot beat a buy-and-hold strategy (Carhart, 1997; Elton et al., 1996); decisions
that are not economically rational (Shefrin, 2001); systematic underpricing of initial public offerings (Ritter and Welch,
2002); and over-payment for acquisitions (Andrade et al., 2001).
Academics view of how to resolve their dichotomy with practitioners is encapsulated by Merton (2003) who points to the
rich set of tools available to investors, and argues that the research challenge now is to put them into practice: I see this
issue as a tough engineering problem, not one of new science.
Practitioners, who should form much of nance researchers audience, continue to display little interest in applying
Mertons tools. These practitioners usually have extensive experience and are well-trained, often holding nance MBAs
taught by the very academics who criticise them. They are familiar with investment theory and strongly incentivised to
deliver high performance: their neglect of investment theory suggests it offers limited value.
Rather than dismissing practitioners as misguided, my objective in this research is to examine factors they believe
contribute to the dichotomy, and hence test the practicality of Mertons proposition.
Analysis proceeds in two steps: rst, through use of established literature to identify deciencies in theory behind nancial
decision making; and second by using interviews with investment decision makers to obtain their reasons for neglect of theory.
This leads to a conclusion that is the opposite of Mertons: neoclassical investment theory cannot survive contact with the real
world because it is impractical to apply, and because it omits factors that investors consider are important to their decisions. The
frontier of investment research, then, should be to seek a new basis or approach to investment theory.
This analysis extends the conclusion of Keasey and Hudson (2007) that nance theory is internally focussed and ignores
the context in which empirical data is established. It sits within studies of the economics of economics by Frey (2006),
Faulhaber and Baumol (1988), and others; and also within the critical nance literature developed by Frankfurter (1994),
Langer (1997), McGoun (1997, and later) and others.
Looking ahead, the next section backgrounds the study by considering motives that might support the paradox where
academics advocate theory that practitioners ignore, describes limitations to research that prevent it matching practice, and
provides information on conduct of the practitioner interviews. The following section discusses research evidence that core
nance paradigms are not widely applied in the eld, and Section 3 draws on evidence from interviews with fund managers
to explain why they make so little use of normative decision theory. I close with a brief discussion of why investment theory
so often fails attempts to apply it in the eld.

1. Research background and interview process

This section briey identies motives for varying use of nance theory; discusses gaps in existing research methodologies
that interviews could ll; and describes the process of practitioner interviews.

1.1. Motives for advocating or ignoring investment theory

Discussion above identied a paradox whereby nance academics and researchers rely on neoclassical investment
theory, whereas practitioners make little use of it. This paradox reects different preferences to use or ignore theory
presumably because of its expected contribution to the needs of potential users. So it is useful to discuss the various motives
as background to subsequent analysis.
The most obvious reason to base investment teaching, research or practice on theory is a rational, economic response to
use materials that can add value. The evidence to support such use, though, is mixed. For academics, their students do not use
the theory after graduation. For researchers, Section 2 summarises extensive evidence that investment theory is not
supported empirically and so forms a questionable basis for research. And, as we will see, practitioners use little theory. This
is why the economics of nancial economics are generally unfavourable.
The second motive for use or not of theory is to enhance human capital, which might be thought of as the set of
competencies and knowledge that are used to help improve performance, or signal an ability to add value. For academics,
neoclassical investment theory is well-established, is didactically tractable, and intuitively appealing (Welch, 2000). For

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researchers, the theory is well suited to analysis using readily available markets data. Thus existing theory serves the
professional needs of most academics and researchers. For investors, though, the theory is very formulaic, leaving limited room
for individual skill: its application appears to diminish their human capital and so does not meet their professional needs.
A third, non-rational motive to make use of, or not use, theory has many potential bases. As just one example, universities
and funds management rms sit within mature, oligopolistic industries that compete around non-economic measures such
as brand and reputation. Thus herding is common, and there are few returns to major players (as opposed to boutiques) from
taking risk by moving away from the consensus.
In summary, modern investment theory fails to meet the professional needs of its major stakeholders to varying degrees:
academics are not able to convince students to apply its teaching in the workplace; researchers have not extended theory to
develop an asset pricing model that is robust to real-world conditions; and investment managers do not have techniques
that enable them to outperform their benchmarks. Neoclassical investment tools, however, seem to suit the human capital
needs of academics and researchers who stick with irrelevant theory even though they should be actively searching for a new
set of tools (Keasey and Hudson, 2007). Although it is not easy to elicit the true motives for persisting with these
unsatisfactory techniques, the following research is alert to a range of economic, professional and human factors that drive
individuals choices about use of nance theory.

1.2. Limitations in traditional research methodologies

This section discusses shortcomings in existing research techniques that sustain gaps between investment theory and
practice.
The scientic method attributed to Descartes (1637) and others involves a sequence of observing behaviour, developing
explanatory hypotheses, and then validating them with further observation and analysis to establish empirically based
theory. This descriptive methodology is not the usual practice followed in developing nance theory. Rather it evolved as a
quantitative discipline, with normative theories that have been developed intuitively, and analytical frameworks that are
mathematically tractable and make use of the rich amount of available market data.
An important barrier to building more empirically based theory is that it is difcult to monitor settings where investment
decisions are made. Thus scant attention is paid in nance . . . to address profound questions about how decision makers
make sense of the knowledge that they have somehow acquired (Bailey, 2005, p. 65). As a result, CAPM, modern portfolio
theory, agency theory, rational pricing and other core nance principles were developed in isolation from data and
observation of practices in the eld. Not surprisingly, they break down in practice and as discussed below in Section 2 are
disproven by empirical analysis.
A related shortcoming is that analysts tend to observe decisions indirectly through accounting and markets data. This
limits knowledge of processes at the individual investment level, and researchers cannot describe intuitively important
drivers such as rm risk and its inuence on performance, and the nature and effects of governance. Nor can they observe
pathways followed by decision stimuli from rst emergence through market reaction to incorporation in prices.
An important consequence of the inability to observe decision processes is that it is impractical to recognise when
statistically robust relationships are actually spurious. Consider, for instance, the well-known disposition effect (Shefrin and
Statman, 1985) where investors sell winners ahead of losers. This is usually attributed to an irrational bias against
acknowledging loss. But it could just as easily reect expectation of mean reversion where past losers would outperform past
winners.
Another barrier to understanding nancial decision processes is that researchers have not developed databases that include
important rm parameters such as insurance and risks more generally, and non-nancial measures of operations. The last is
important because of links between nancial and operational performance, such as higher protability of rms which adopt
corporate social responsibility (Siegel and Vitaliano, 2007). Also lacking are databases of difcult-to-quantify variables that are
intuitively signicant to rm performance such as Board effectiveness, company ethics, and employee competencies.
A further research shortcoming is that many conclusions are sensitive to the analysts criteria and methodology, and so
can disappear with a shift in perspective (Fama, 1998). A good example relates to the Super Bowl stock market predictor
which says that if the Super Bowl (the championship of American football that was rst played in 1967) is won by a team
from the old National Football League then the US equity market will be up that year; and vice versa. After a string of
successful predictions, the indicator came to prominence through a Journal of Finance article by Krueger and Kennedy (1990),
which found it delivered a return double that of a buy-and-hold strategy. This is actually a classic example of model
survivorship bias with in-sample validation. In the late 1980s, someone identied that of all possible predictors of the stock
market direction ranging from hemlines to demography the Super Bowl performed best. Krueger and Kennedy (1990)
simply conducted a test of this observation using the same data that led to its identication. If the predictor reected co-
incidence, then it should break down, which is exactly what happened: a review over the next two decades by Kester (2010)
shows the predictor almost exactly matches results of a buy and hold strategy.
Whilst the Super Bowl predictor is treated light heartedly, it shares much in common with tests of many better-accepted
market predictors ranging from technical trading strategies (Park and Irwin, 2007) to dividend:price ratios (Cochrane, 1999).
Analyses of their performance use in-sample historical prices to test surviving models: each is a rule or technique that has
become popular (presumably because it works in practice) and evaluations use the same historical data that led to its
popularity.

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Along similar lines is what Brown (2011) terms ex post conditioning in which observing a pattern in hindsight can attribute
cause and effect, whereas the outcome is tautological. This is particularly true of nancial decisions because many are
endogenous and can set up predictable price patterns. For instance, few acquisitions are announced after bad news, and Brown
(2011) cites the decision by Walt Disney to cancel its acquisition of the Muppets in 1990 after the death of the targets CEO, Jim
Henson. So acquisitions tend to be preceded by favourable news and followed by neutral (or delayed unfavourable) news.
Thus the timing of market information and corporate events is not random or exogenous as many studies assume, but is
subject to considerable discretion within the rm. In this way, managers perfectly rational behaviour can result in seemingly
biased price patterns.
It is certainly difcult for nance researchers to conduct real-world experiments (although see Camerer (1998) for an
interesting exception) and most readily available data is limited in scope and history. The consequence, though, is that it is
unrealistic to expect that nance theory which is developed intuitively and in isolation from practice will match real-world
experience.
One way to link theory to practice is to make better use of complementary research techniques, in this case practitioner
interviews as described in the following section.

1.3. Practitioner interviews

This study draws from material collected by the author as part of a broader investigation into the decision processes of
institutional fund managers, and reports reasons why they make so little use of investment theory.
A total of 34 semi-structured interviews were conducted at 21 fund management rms in Istanbul, London, Melbourne
and New York during the second quarter of 2012. The pool of interviewees was developed through suggestions from an
investment consultant, referrals from interviewees, and a small number of personal contacts and those with a LinkedIn
prole. Interviewees were mostly male (97 percent), and aged between 35 and 60 years, with between two and 30 years
experience with their current employer; all had tertiary qualications.
Interviews began with an assurance of condentiality, and followed the approach recommended by Hermanson et al. (2012)
to use broad questions that allow deep delving into issues, rather than populate answers to a questionnaire. Interviews were
recorded and took between 50 and 180 min, and the process generally followed the framework advocated by Coleman and
Pinder (2010) and Strauss (1987). This article reports responses to two specic questions: What corporate nance theories do
you use in your job? and It seems that nance theory rarely survives contact with the real world: why is that?
This sample is clearly small relative to the number of decision makers in the 70,000 mutual funds around the world (ICI,
2012). Moreover it is biased to the extent that subjects self-selected by agreeing to the interview. So there are limits to the
representativeness of results. Conversely the approach and sample have strengths. First, interviewees were portfolio
managers or Chief Investment Ofcers with decision making authority over investment. Most interviewees work for names
and manage multi-billion dollar equity mutual funds, so their fund families hold a signicant portion of funds under
management. Thus the interviews capture opinions with marketplace signicance. Second, the sample is large enough to
validate conclusions by putting them to interviewees in subsequent discussions. The geographical spread also gives a range
of perspectives and had sufcient interviews in each city so the last few could be used to ensure conclusions are robust to
testing against experienced investment professionals. Thirdly, interviews were face-to-face in managers ofces and the
informality enabled probing of rationales and granular responses that are impractical in surveys. Moreover, as is typically
found in qualitative research, a point of diminishing returns is reached relatively quickly (e.g. Danneels, 2007).
Perhaps most importantly the only way to gain direct insight into the decision processes of investment managers is to ask
them. Observation requires analysts to infer reasons for behaviour. Surveys inevitably prejudge motivations by the design of
questions and constraining choice of answers. Interviews are certainly not a perfect data source, but they do offer an
additional perspective on investor thinking.

2. Shortcomings in investment decision making theory and tools

The paradigms of neoclassical investment rest on what Jensen and Smith (1984) call fundamental building blocks (see
also Dimson and Mussavian, 1999). Three of these are theoretical: efcient markets (Fama, 1970), agency theory (Jensen and
Meckling, 1976), and a positive link between security risk and return (Sharpe, 1964). Several others are empirical, in that
they are based on observation, with limited theoretical support, and include portfolio theory (Markowitz, 1959), and factor
models of asset prices (Sharpe,1964; Fama and French, 1993). The paradigms rely on assumptions from economics that
investors unconditionally seek to maximise expected utility, prices are based on fundamentals and hence rational, and
demand curves are at or downward sloping (Muth, 1961).
This section surveys research evidence in relation to the practical shortcomings of these paradigms as they affect investor
decision making.

2.1. Market efciency and investor expectations

The concepts of efciency and rational expectations are central to modern investment theory, which assumes that:
investors form realistic expectations of securities future risk and return, and use this as the basis of valuations; markets

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efciently match investor expectations to reveal appropriate prices; and expected return compensates investors for bearing
risk (Merton, 1973).
Considering expectations rst, these can be formed from historical data, de novo without any prior conceptions, or
through a combination such as adjustment of historical risk and return in light of expected economic circumstances. There is
no evidence, however, that even the best econometric techniques have anything more than trivial ability to forecast security
performance.
This is particularly true of returns, which at most have weak auto-correlation over days and mean reversion over years
(Cochrane, 1999). Although forecasts of return volatility have more success, even the most sophisticated models cannot
predict more than 3040 percent of variation in the next days volatility; predictive ability drops off rapidly, and explains less
than 20 percent of variation beyond about ten days (Andersen et al., 2003).
Another important strand of conventional investment theory is market efciency where security prices fully reect all
available information (Brown, 2011). To the contrary, there is evidence that even unskilled use of available security
attributes can help in predicting returns. For instance, looking a year or two ahead, up to about 40 percent of returns are
predictable with dividend yield (Cochrane, 1991) and price momentum (Jegadeesh and Titman, 2001). Other simple
approaches seem to work, too, so that buying and selling securities to match investment decisions reported by corporate
ofcers outperforms markets across countries and eras (Fidrmuc et al., 2006). Similarly investment in small companies and
those with low price-earnings ratios delivers superior returns, and behavioural nance provides a wealth of further evidence
that markets are not efcient or rational (Hirshleifer, 2001; Shefrin, 2001).
Another violation of market efciency is that fund managers and other experienced investors commonly employ some
form of technical trading (Menkhoff, 2010). These techniques typically make reference to historical prices, as do other
approaches used by experienced investors. For instance, executives exercising options in their own rms tend to do so
around a previous high (Heath et al., 1999), showing that even those who have the most information about a rm use
historical valuations as anchors.
The nal relevant corollary of market efciency is the nexus between securities return and risk, so that one of the most
fundamental questions in nance is understanding the economic forces that describe this relationship (Campbell, 1996).
However, repeated studies variously conclude that it is signicantly positive, signicantly negative and insignicant (for
surveys of these ndings, see Anderson et al., 2009; Bali, 2008; Scruggs, 1998).1
Field applications of investment theory such as portfolio construction rely on identiable, stable relationships across
asset classes and securities, including a linear risk-return link. Because these associations break down when applied, theory
offers little attraction for practitioners.

2.2. Rational security pricing

A key assumption of market efciency is that security prices are set rationally on the basis of price-sensitive information
so that they equal the present value of expected cash ows discounted at a risk-adjusted rate of return. Information, then,
should be a vital element in security prices.
Evidence, however, suggests that much public information, at least, is irrelevant to securities prices. Fair (2002), for
instance, tracked the United States S&P 500 futures contract between 1982 and 1999 to identify moves of greater than 0.75
percent within any 5 min (about seven standard deviations above average). He found 1159 examples, and then searched
newswires at that hour, but found that 90 percent of moves had no identiable cause. Nor can public data explain large price
changes in the US Treasuries market and the UK FTSE 100 Index (Fair, 2002). Thus large moves in major securities markets are
often not related to public, identiable ows of information.
A second indication of limited value contained in information comes from literally thousands of event studies over
decades which consistently show that news of events that intuitively should permanently affect stock prices usually brings a
cumulative abnormal return of no more than a few percent that rarely lasts more than a day or two (Brown, 2011). The small
statistical signals of price impact disappear soon after a wide variety of corporate shocks (Coleman, 2011) and unanticipated
events (Brooks et al., 2003). There are few exceptions to this pattern, other than industry deregulation or similar
Schumpeterian shocks (Pettus et al., 2009), and targets of changes in control such as acquisitions (Moeller et al., 2005).
Most analysts interpret this rapid disappearance of price response as evidence that prices on average adjust quickly to
rm-specic information (e.g. Fama, 1991, p. 1062). Whilst this might argue for a quick end to daily abnormal returns, it
does not explain disappearance of cumulative abnormal returns which indicate permanent price adjustment to new
information. Market responses to even the most surprising information merely reect over-weighting of new information
that is quickly corrected, and event studies just measure noise (Coleman, 2011).
Complementing the limited value of information is the possibility that it lags prices, so that price falls bring on bad news,
and vice versa. As a result, information can be pro-cyclical (Cornell, 2001), which is understandable given the tendency for

1
These mixed ndings should not be a surprise because nance denes return and risk, respectively, as the mean and standard deviation of samples
drawn from approximately normally distributed returns. However, because the standard deviations of such samples when drawn randomly will not be
related to the mean (Stuart and Ord, 2009), one would not expect a link between security returns and risk, and so any relationship that is detected is due to
sampling bias.

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managers to get all bad information out at once, rather than face a continuous drip feed of negative reports. Similarly,
analysts can induce feedback because they typically downgrade rms after release of bad news, and exacerbate the price
decline. (The opposite, of course, tends to happen after release of good news.)
It seems that new public information, no matter how surprising or intuitively important to security prices, has limited
value for investors. This is logical because its arrival still leaves estimates of a securitys value subject to the same magnitude
of uncertainties.
Another important assumption behind rationality in nance is that investors have an increasing preference for securities
selling below their rational price. In highly liquid markets, this means that (say) if the price of a stock falls below its
fundamental value, arbitrageurs can buy it at no risk, so that the normally downward sloping demand curve is close to at (if
not perfectly elastic). Many core asset pricing theories rely on a horizontal demand curve, including CAPM, the Modigliani
Miller theorem and rational investment (see Scholes, 1972).
This assumption, too, breaks down in the real world as at least some investors appear to have an upward sloping demand
curve, where demand for investments rises with price and so is procyclical (Adrian and Shin, 2008). The most obvious
evidence can be seen in the success of momentum trading strategies that increase the size of a portfolio as prices rise. For
instance, Lee and Swaminathan (2000) show that price momentum in equities persists for at least three years; and that
trading volume is directly related to returns. More formally, price changes are known to co-move with investor demand, so
that Cha and Lee (2001) found a cointegrating relationship between equity mutual fund ows and the S&P 500 Index with bi-
directional causality (that is positive feedback). Other examples of procyclical investing include herding by institutions
which follow the investment decisions of competitors (Sias, 2004), and many of the trading rules used by technical analysts
(Park and Irwin, 2007).
Another reason to question the rational, information-based valuation of securities is the regular appearance of bubbles
and other obvious price misalignments.
In summary, there is clear evidence that the core tools of investment do not withstand empirical testing, and that their
theoretical premises such as efcient markets and a rational basis for prices are unsupportable. It should not be a surprise
that practitioners with a good grounding in these tools will reject them, which is borne out by evidence that as many as half
of all nancial analysts never rely on rational pricing (Francis et al., 2000)

3. Practitioners experience in applying investment theory

This section complements earlier discussion by reporting investment managers own words to describe their reasons for
not applying investment theory in decision making.

3.1. Extent of use of investment theory

The table below summarises the proportion of managers who use investment theory, and for the majority who do not
the reasons why (Table 1).
Most (88 percent) of the interviewees reported that they make little use of investment theory, many of them making
specic mention of CAPM, portfolio theory, and asset pricing. Of the four interviewees who report using theory, two were in
London, with one each in Istanbul and New York.
The most common reason for not using theory (which was given by 34 percent of interviewees) is that the data are not
available to populate theoretical models. The second most common reason (28 percent) is that theory does not work, with
several interviewees observing that return is not related to risk. The other signicant reasons (given by a total of 32 percent
of interviewees) for not using theory are that it does not make use of data that they think is price sensitive (such as
management skill), or that they have a general preference to use non-quantitative approaches such as intuition and
judgement.

Table 1
Fund manager opinions on application of theory.

Istanbul London Melbourne New York Total

Number of interviewees 6 11 4 13 34

Panel A: Reported use of investment theory (percent of interviewees responding)

Little or no use 84 80 100 93 88
Considerable use 16 20 0 7 12

Panel B: Reasons for not using investment theory (percent of interviewees responding)
Theory does not work 18 25 46 28
Data are not available 16 46 50 32 34
Theory does not use intuitively important data 18 16 13
Preference for a qualitative approach 50 18 25 16 19
External constraint 16 3
Skills not available 16 3

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The balance of this section addresses each of the main reasons why investment managers do not follow theory, and
provides explanations using quotations from interviews with them.

3.2. Data are not available

The most common reason that managers give for not applying neoclassical theory in their investment decisions is that it
requires numbers that cannot be accurately estimated. This reects the fact that nances normative decision paradigms are
highly mathematical and require extensive data about the future (particularly mean and variance of individual securities
returns, and covariances between them). But, as noted above, historical data has little forecasting ability and managers nd
no other practical way to populate the models.
We truly make minimal use of academic theory, in fact minimal use of quantitative analysis. There are error bars
around all our estimates, and we just dont have the ability to quantify many of the most important variables. (London
venture capitalist)
All data relates to the past: we cannot predict beta and other stock parameters. (New York long-short manager).

Theory is too mathematical for data that is not robust. (London fund-of-funds manager).
Most managers have a good knowledge of asset pricing models, and express frustration that such an intuitively attractive
technique cannot be applied.
The reality of CAPM is that its calculations are fraught with difculty. First the risk free rate can be articially
inuenced. The second input is beta, whose calculation is questionable as the time period involved makes a difference.
I have no conviction about the persistence of the various inputs as my experience is they vary signicantly. I have even
less conviction in the risk premium which has such a huge range that you can come up with any answer. (London
quantitative manager)
I dont have a good way of forecasting volatility (Istanbul CIO)
We cant estimate future volatility. Looking ahead we guess, based on heavy thought. It is judgemental, not
mechanical. (New York global thematic manager)

3.3. Theory does not work

The second most common reason for not using investment theory is that it does not work. Again most of the managers are
very familiar with the techniques and are under pressure from institutional investors to demonstrate robust investment
processes, but they have no faith in the theory.
We have dispensed with theory. It took me a long time, but nance theory is a complete distraction. (New York global
thematic manager)
I dont believe in most of the nance theories. (New York value manager).
I do not use much nance theory. It breaks down in practice because of the huge ow of information, the limits on
what we can do, and difculty in quantifying information. (Istanbul international fund manager)
Following the global nancial crisis (GFC), many managers report feeling pressure from their own rm and investors to
improve risk management. They report that these techniques, too, are not practical to apply.

During the market turmoil in 20078 all the quantitative risk models broke down. They are ne during the 99 percent
of times when the market is normal, but they cannot handle the tails. They cannot project turning points or high
volatility, the sort of events that fund managers worry about. By the time they have caught up with the market its too
late to be of value. (London equity manager)
No matter what tool you use, it is backward looking. Standard deviation, VaR and so on are not good risk measures
because you can only calculate historical parameters. We can never know future risk. (Istanbul equity manager)
From a fund managers perspective, the most useful theories relate to security selection and portfolio construction. Most,
however, report an inability to apply these tools.

Our quant models are pragmatic, atheoretical. We dont use theory. Take CAPM: it hasnt worked from the beginning,
thats the whole low beta anomaly. Once you nd that the basic foundation that you are being paid for risk does not
hold, then a lot of the things in nance theory begin to degrade. (New York investment strategist)
In our experience portfolio construction is subtractive of the process. We want to bet on our research, so we
overweight cheap stocks. This works because returns by quintile are monotonic so lowest value stocks
outperform. Our portfolio construction rules are simple, and designed to prevent driving us to insanity. (New York
value manager)

Please cite this article in press as: Coleman L. Why nance theory fails to survive contact with the real world: A fund
manager perspective, Crit Perspect Account (2013), http://dx.doi.org/10.1016/j.cpa.2013.02.001
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CAPM is of no real use in portfolio construction. We build a pool of individually attractive stocks, then look at their risk,
at how the companies look against an Index and make sure we are not getting too concentrated, or are exposed to
possible unintended consequences or risks (New York small cap manager)

The only time I take much account of portfolio theory is if I have two stocks with the same outlook and one is higher
risk, then I will go for the lower risk stock (Istanbul international fund manager).
Several managers reported that there was no theory to help with important elements of their decisions.
I despair about my academic colleagues. They provide no assistance in making critical decisions, even as basic as what
securities to buy. (London SWF manager)
Theoretical concepts do not t readily into the processes that we must follow to reach investment decisions. (Istanbul
international fund manager)

3.4. Theory does not incorporate intuitively important data

Managers do not rely on quantitative investment techniques because of the difculty in tting their investment
framework and process into neoclassical nance theory. In particular, managers emphasise the importance of qualitative
data such as that gained from visits to companies they may invest in, and non-rational aspects of markets, especially
behavioural factors. However, they cannot readily incorporate this qualitative material into standard theory.
To form our investment themes we apply brainstorming and research. We tap into all the resources around us. A lot of
the ideas and insights are observations made from listening to what company managements to tell us what they are
thinking. So we develop big ideas, but from the bottom up (New York global thematic manager).
We really rely on a personal view and expectations about future conditions. Investment involves our own thinking,
culture, and out of the box perspectives: it is almost spiritual. (Istanbul balanced manager)

Many managers believe that they have an ability to stand apart from market mispricings and apply their skill to
advantage.
I am a behaviourist. You have to be in this business. A fund manager just cannot believe in efcient markets. You have
to nd mispricings and that boils down to understanding why you are right and the market is wrong. (London equity
manager)
Im always surprised at how much psychology matters. There are also forced sellers and buyers in the market for
various trading reasons. A rating may change and the fund cant hold a stock or bond; and the reverse happens when it
recovers. So supply-demand ows are not controlled, and can be accelerated or slowed by factors beyond the
investors control. (New York long-short manager)

3.5. Preference for a qualitative approach

Because most managers nd it impractical to apply data-intensive nance theory and so generally restrict
quantitative analysis to conventional DCF calculations, it is not surprising that they report heavy reliance on qualitative
techniques.
The most common reason for using qualitative analysis is the expectation that it will outperform quantitative, theoretical
approaches.
I dont believe in academic theory, all the curves and lines and equations. We cannot look far ahead and so much of the
outlook has a qualitative basis. Quantitative assessments are useful for monitoring, but they have no relevance to my
investment decisions. (London equity manager)

All the investment cases are wrong: things never happen exactly the way you think they will. Thus our future thinking
is far more qualitative, because in our experience the biggest driver of returns is not what you pay but the business
that you buy. If you buy the wrong business cheaply that can be a disaster. We spend a lot of time building models, but
its more to help structure the debate. (London private equity investor)
A second reason to follow qualitative investment processes is a preference by managers to use their own proprietary
skills.
Managers prefer to use their creativity rather than a formula. (London fund-of-funds manager)
The most important parameters in the alpha generated from my portfolio are not economic forecasts but the ideas
about security prices (Istanbul equity manager)
In our tops down thinking we use judgement and strategising. For us, building a portfolio has too many judgements
and non-quantiable decisions to use the theory. (Istanbul international fund manager)

Please cite this article in press as: Coleman L. Why nance theory fails to survive contact with the real world: A fund
manager perspective, Crit Perspect Account (2013), http://dx.doi.org/10.1016/j.cpa.2013.02.001
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A third reason to prefer a qualitative approach is the emphasis that managers place on the importance of qualitative data,
which even though not available readily in standard format is used by virtually all of them.
Managers like using qualitative data because there is so much of it. (London fund-of-funds manager)
The way I analyse stocks is to talk to suppliers, company managers and so on to examine their future outlook. Then we
do traditional cashow analysis and forecast returns and price. The process is a combination, but much more
qualitative than quantitative. (London equity manager)
3.6. External constraints

One theme that came through was the number of constraints that managers face on their decisions. Some were obvious,
but others were more subtle such as institutional limits and self selection.
The most obvious constraint is that all managers run open ended funds and must cope with volatility in funds under their
management.
In an open ended fund, success brings too much money. (London fund-of-funds manager)
Sadly clients dont manage their investments the way they should. In crashes, everything gets dumped, and we see
rst class companies offering fantastic buying opportunities. But our clients Investment Committees panic and sell. It
is heart-breaking. The opposite happens, as well. Thats human nature. Its exactly the opposite of standard economic
theory, when buying should move against price. (New York global thematic manager)
My own experience gained whilst visiting over 20 different institutions in a few weeks showed up few differences in their
physical fabric, employee characteristics and internal processes. This was obviously apparent to managers, too.

Its an odd thing about why fund managers sit in buildings with other people. They should be out and about, being
creative as part of their job. Sitting in an ofce just institutionalises you, and makes you think in xed ways. (London
equity manager)
Organisational behaviour makes you herd. This [London] is groupthink City. If you have an outlandish idea at one of
the large funds you need to get it through a committee that may be as big as 20, and that is impossible. (London fund-
of-funds manager)
The nature of an institution is to constrain its managers. They are part of a group, they owe it allegiance, need to t in
with an esprit de corps. (London fund-of-funds manager)

People with strong views who adopt long term, value-oriented strategies buying on setbacks and selling on over-
pricing are very rare in large fund institutions because they cannot survive. Typically the top people in funds do not
want any prima donnas. So their managers worry about career risk. Its the hedge funds that are taking the big, punchy
positions. (New York equity manager)
Institutions are process oriented they have to be because they are consultant driven. If you dont have robust
processes you get marked down. This is why start ups do well they are their own people with a lot of energy, perhaps
with aws. Then they succeed, they pitch to the consultant and get forced to hire a risk guy, set up an Investment
Committee and it kills everything that drives their success. (London fund-of-funds manager)
Few managers were willing to acknowledge the extent of limits on them, but one was more forthright.
Overall, then, I am quite constrained. There are limits from the regulators on what I can hold in terms of minimums in
an equity portfolio. There are also controls from risk management and decisions of the investment groups. (Istanbul
international fund manager)
The constraints on managers were not quantied, but their prevalence does qualify the assumption of agency theory that
agents are largely free to make their own decisions.

3.7. Use of theory undermines managers mystique

Comments in several interviews conrmed the intuition in Section 1 that it may not be in managers interest to
acknowledge and adopt nance theory because it would lead to an investment style that appears mechanical and hence
readily replicated. This would reduce their discretion and the satisfaction from their job, as well as the value of their personal
skill set or human capital. None explicitly stated this as a reason for not using theory, but it came through indirectly.
Fund managers whole belief system is that their judgement is right. Otherwise they couldnt be an active manager.
(London fund-of-funds manager).
Certainly we see the same data as everyone else, but we think that we understand it better, or have done more in depth
analysis. (New York long-short manager)

Please cite this article in press as: Coleman L. Why nance theory fails to survive contact with the real world: A fund
manager perspective, Crit Perspect Account (2013), http://dx.doi.org/10.1016/j.cpa.2013.02.001
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Not everyone sees what we see, or can execute what we can (London private equity investor)

Fund managers use their own skill and ideas (London equity manager)
There is a lot of pride that comes in the responsibility of investing other peoples money, but it comes when you can
hold your head high. (New York private equity manager)
The most telling statement was almost a throwaway line as I was wrapping up one interview:

The portfolio manager puts intuition and feeling into his work: he is not a pilot for the reports or the investment
process (Istanbul balanced manager).

4. Conclusion

The material above concludes that neoclassical investment theory is invalidated by real-world data, and reports results
from interviews with its principal potential users (the managers of large investment funds) on reasons why they nd it
impractical to apply. This suggests that investors are not biased in the sense that they choose not to follow economically
rational processes (e.g. Baker and Nofsinger, 2001), but act in response to evidence that theory does not work in practice.
The main reason investors do not use the intuitively attractive normative theories is that their core precepts such as the
risk-return nexus and rational pricing do not hold; and the models require expected values which relate to the future and are
either not available or are too imprecise.
A second reason why practitioners do not use theory is that it ignores data that is available to them and which they believe
is price-sensitive. Most follow an integrated investment process that incorporates macroeconomic, industry and rm
features with signicant qualitative inputs such as themes or judgements about outlooks, and less precise measures such as
rms managerial skill, governance and product quality. A simple example of important data omitted from traditional
models arises from the common belief that the CEO is the single most important factor in a companys stock price
(Jackofsky et al., 1988), and ndings from organisational behaviour literature that the best measure to predict performance
in any occupation is cognitive ability (Ones et al., 2005). Investors see the need to incorporate these and many other similar
performance drivers in their analysis, and they can dominate theoretical approaches.
In closing, let us return to the argument by Merton (2003) that future investment research should address ways to better
apply neoclassical investment theories and tools. Given the good reasons found here for why they have not found application
in the decades since they were published and entered mainstream teaching and research, it may be appropriate to consider a
more revolutionary adaptation of investment decision processes that will give theory a stronger nexus with practice (Smith,
2009). Intuitively this would be a multi step process which starts by setting out the actual behaviour of markets, investors
and managers. The next step is to test these observations against existing theories, discarding those that fail and
strengthening useful theory. The nal step in the classic scientic method of observe-hypothesise-test is to build and
validate a new nance paradigm.
Finance is not alone in failing to capture evidence from eld research and impounding it in better theory to improve
decisions. These gaps in actioning knowledge have been recognised in medicine (which like investment is an archetypal
practitioner-driven discipline) under the rubric of knowledge translation (Straus et al., 2009). But, no matter what the
discipline, theory stagnates in the absence of researcher-practitioner interaction and feedback, and so research practices
must change to better synthesise and disseminate knowledge. Investment theory requires just such a change.

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manager perspective, Crit Perspect Account (2013), http://dx.doi.org/10.1016/j.cpa.2013.02.001