Paradigm confusion and manufacturing conspiracies
By Daniel M. Ryan
Many of us know what a "paradigm" is, thanks to the popularity of Thomas Kuhn. His theory of scientific discovery, which divvies up "normal" science and paradigm-shaking "extraordinary" science, is well-known too. So is the main example attached to it, to the point where more than a few word-association tests that use "paradigm" would elicit "relativity" or "Einstein."
Paradigms, though, exist outside of the perhaps-still-rarefied world of theoretical science. They exist even beyond the wider field of academics itself. In fact, there's a paradigm wherever there's intellectual capital being used.
The purpose of a paradigm is to turn extraordinary inquiries into normal ones. Without an assembled paradigm, without any framework linking ad hockery with ad hockery, all inquiries are "extraordinary." All problem-solving processes end with surprise or shock. Without a paradigm, the only mental way to contain the resultant uncertainty is to rely upon rote memorization and fixed procedures, with "that's the way it's done" or "it works" as the only justification for each of them.
With a paradigm – a set of interlocking subject-explaining principles that can be reasoned with – comes liberation from rote memory and inflexible procedures. Now, the unprecedented case can be related to one or more principles that lead to a satisfactory solution to that case. Taking a theoretical, or thoughtful, approach can yield a benefit.
Scientists' accumulation, use, and exchange of intellectual capital in this manner, describes how a science evolves. This process is also applicable to less exact fields where thought and mental effort are required. The difference between more workaday paradigms and more intellectual ones is that the former tend to use rules of thumb with principles that sometimes conflict. As a cultural matter, the dividing line tends to be quantification, although this line is blurred and inexact. (Field engineering is far more quantified than academic-level literary criticism, or even biology.) Whether tight or loose, whether theoretically neat or open-ended, though, any line of work where thinking is a necessary has either a pre-paradigm or a real one.
One of those fields is, of course, capital allocation. This field includes stock-picking, portfolio management and money-lending. It's also the field in which a real humbling has taken place, thanks to the subprime-mortgage blowup.
When huge mistakes come to light in the capital-allocation field, there tend to arise conspiracy theories from the outside. The root of them is prior respect for capital allocators' expertise plus the common-sensical observation, "if those people were so dumb, they would have been weeded out of the field a long time ago. Hence, they're playing dumb and concealing something. They certainly look like they've got something to hide." The explanation that they were under the spell of simple groupthink (and what they've got to hide is embarrassment) doesn't seem to penetrate, as it's subject to use of the same rule of thumb: "if they were, then why now? More to the point, why not all the time? Why is it now? Some of ‘em are still profiting; I've seen it. Maybe they all are. They all look rich, even now."
In order to see what this kind of common sense misses, I'll apply it to another time and field – the one that's bound to Kuhn's theory. Physics, at the time when young Albert Einstein had just had published his Special Theory of Relativity: "There's something funny here. All of those physicists couldn't have been that dumb; they're experts in their field. They should be able to read and understand what that Einstein fellow saw and wrote, especially since his paper was published in one of their journals. Hence, they must be trying to drum the fellow out because he rubbed ‘em wrong in some way. It has to be that, because these people aren't as stupid as they're acting. Is there some sort of conspiracy afoot to shove him out?"
It's the same line of reasoning, only shifted to a different calling. Thanks to the fact that Einstein had an extraordinarily high I.Q., questions like those weren't pressed that much. The rhetorical question "are those people stupid?" was answered with, "they are compared to him." Had Einstein's I.Q. been about the same as that of the standard physicist, though, the above question wouldn't have been easy to answer in that way.
It was fortunate that he was, because that conflict between smart and genius laid bare the limits of paradigmatic thinking. Try as we might, the paradigms we use cannot reduce all extraordinary inquiries to normal ones. Every now and then, every paradigm – every one of them – faces a crisis of ignorance when an extraordinary inquiry throws it into disarray. Even pure mathematics has had its paradigm crises. (Ask a mathematician about Kurt Gödel, and why the question "what is the cardinality of the reals?" is now considered impossible to definitively answer, and you'll hear of one.) Capital allocation has had its paradigm crises too.
Considered broadly, the intellectual capital associated with capital allocation works on asset mispricing. If an asset is underpriced, it should be bought; if overpriced, it should be sold. "Buy low, sell high" is the bedrock principle of capital allocation. The associated paradigm consists of principles that seek to identify what is ‘low' and what is ‘high' for various assets under certain conditions. In the largest sense, all capital allocation is arbitrage in found (sometimes ostensible) conditions of uncertainty.
The above maxim is, of course, too vacuous to be used. Thus, the capital-allocation paradigm deals with the hows of the task. Some kinds, such as currency arbitrage, are complex but fairly mechanical: "Compute the effect of: borrowing money in currency A for n days; selling it for currency B; loaning it risk-free in currency B; buying a forward or futures contract that gives the right to convert what you'll have in B, plus n day's earned interest, into currency A n days hence; and, using the proceeds of the forward sale to settle the currency A debt. If you wind up with more than x%, book it. If you wind up with less than -x%, reverse A and B and then book it. If neither, sit and wait for the return on that operation to go above x%" Whatever ‘x' is, is arrived at through an internal-rate-of-return criterion.
Others are more fraught with uncertainty, and tend to be expressed as rules of thumb. "Don't lend more than can be paid with 35% of borrower's income allocated to all debt payments." "Don't buy a business, no matter how exciting, unless you can get it for 10 times earnings at most." "When hysteria becomes normalcy, start selling; when depression becomes normalcy, start buying." "'Graham's Law': As you pass an investment to a greater fool more and more times, the probability that the greatest fool will be you approaches one." "Sell in May, then go away." "Buy in January; sell in October." "Don't fight the Fed." "Don't fight the tape." (Some of these maxims or principles do clash with another, which means that a clash-free subset of them makes for a sub-paradigm of a distinct school.)
The "quant" revolution in the investment community had as its aim the seeing through of these maxims. The earliest quants were actually debunkers, taking on technical analysis through demonstrating that price-and-volume-chart interpretation was a subtle variant of the gambler's fallacy. (I have to admit that some chartist methodologies can be easily made fun of as "Sophistikatid Ekonometriks.") As the field grew, though, debunking turned into overturning the maxims that counseled too much caution.
An example would be old money-loaner's customs that sought to make lending as risk-free as possible. Statistical quantage found angles that made for economically profitable loan classes even after previously-shunned defaults were factored in. Junk-bond portfolio investing was built upon this kind of analysis; Michael Milken's angle was, essentially, understanding and relying upon his Hickman. Replacing the cautionary "don't" with the statistically-justified "do only if…" was the secret to his success, as well as that of other statistical quantitative analysts. Because of these successes, statistical (later stochastic) quantitative analysis grew and grew into the new mainstream.
Unfortunately, these successes have been accompanied by troubles every now and then, with the latest one coming close to a disaster. As many of you already know, there have also been conspiracy theories vaunted about to explain what's gone wrong. Manufacturing conspiracies is, once again, a growth industry in financial-markets commentary. Backing them up is the same kind of common sense I used above for illustrative purposes.
Given the fact that an overall paradigm exists in the capital allocation field, and that all paradigms have been subject to crises as a result of extraordinary discoveries which couldn't be normalized within them, it's a better prima facie explanation to assume some kind of paradigm crisis instead. The old political rule of thumb, "never assume ‘conspiracy' when ‘incompetence' will suffice," paints with too broad a brush. It can, though, be retooled to say, "Before concluding ‘conspiracy,' assume ‘paradigm crisis' and see if it suffices."
As a side point, an interesting time can be had by substituting the introduction of relativity into physics for the particulars of any capital-markets-related conspiracy theory. Like so: