The great scientist E.O. Wilson created a major stink over the week-end via The Wall Street Journal by arguing (or at least seeming to argue, among other things) that math skills are less important to most scientists than imagination, theory, concept and intuition. It reminded me of the 1976 SNL send-up of the Gerald Ford-Jimmy Carter Presidential Debate. In the “debate” (shown below — the noted section is about 6 minutes in), Chevy Chase, as Gerald Ford, responded to a difficult economics question as follows.
President Gerald R. Ford: [ sweating ] It was my understanding that there would be no math… during the debates.
Clearly, lots of us, even scientists and others whose work utterly depends upon it, are lousy at math (lots of reaction to Wilson here; my thoughts are here and collected here). As the links demonstrate, much of the warfare is internecine and, while fascinating, beyond the scope of our overall investment discussion here.
What is relevant, however, is an all-too-frequent math-phobia in our profession and a common reliance on ideology over and against what can actually be shown to be true. If nothing else, math allows us to check our work. Galileo rightly perceived that the “Book of Nature” is written in the language of mathematics and Darwin spoke of math endowing us “with something like a new sense,” even if the investment world is willing and often eager to ignore it.
As UC Berkeley’s Edward Frenkel (full disclosure, my younger son is a Berkeley alum) points out in response to Wilson, “One thing should be clear: While our perception of the physical world can always be distorted, our perception of the mathematical truths can’t be. They are objective, persistent, necessary truths. A mathematical formula means the same thing to anyone anywhere—no matter what gender, religion, or skin color; it will mean the same thing to anyone a thousand years from now.”
To be sure, Frenkel’s assertion can be stretched too far. A singular data point, even a very valuable one, is seldom reason enough on its own to make an investment decision. We need lots of data points. Probably more importantly, facts alone — without context and interpretation — aren’t worth much. Moreover, knowing what everybody else already knows and has factored in isn’t going to help. As the expression goes, five dollar bills aren’t going to be left sitting on the sidewalk for long — someone is going to pick them up. And, finally, unless communicated and used effectively — often via narrative — math doesn’t much matter.
In short, data without effective interpretation isn’t very helpful and interpretations often distort data. Whichever side you come down on, think of George W. Bush describing Al Gore’s economic figures as ”fuzzy math” in a real presidential debate in 2000. Moreover, the bias blind spot insures that we will typically be and remain convinced that our own distortions are objective recitations. As I frequently insist (here and here, for example), information is cheap but meaning is expensive.
This problem appears in stark relief in a recent WSJ column by Andy Kessler. As Kessler points out, many pension funds (and particularly Calpers, the California public pension giant) are dramatically underfunded and continue to use investment return projections that are far too high. Whether or not you subscribe to the idea of a “new normal” (and I’m unconvinced), there is very good reason to be concerned about prospective returns over the next 5-10 years (see below, from GMO, or this analysis via Research Affiliates — suggesting 5-6 percent annual equity returns over the next decade — for representative forecasts).
Return projections are far too high across the pension landscape. Accordingly, managing pension funds with something like a 7.5 percent expected annual return (like Calpers) is, to use the technical term, nuts. As Kessler notes, pension assets have returned an average of 5.6 percent annualized sine 2000 and, as outlined above, should see similar results for at least several years going forward. Therefore, “[t]here is almost zero probability that Calpers [and other pension funds] will earn 7.5% on its $255 billion anytime soon” even though the assumption is conservative when viewed within the context of market returns over decades.
The be sure, the politics of pensions makes the entire subject matter highly difficult to deal with. As Roger Lowenstein has shown (and my home town of San Diego evidences), politicians have eagerly settled labor disputes with public unions by offering generous pension benefits down the road in exchange for small current raises. However, that piper eventually has to be paid and nobody wants the necessary tax increases. Moreover, money managers with more realistic projections risk not be hired (or retained) when plenty of competitors will gladly project excess returns as far as the eye can see. And finally, to complete the circle, the higher the expected return, the less revenue that must be collected via taxes. Politicians see it as a win-win (if only in the very short-term). In this instance, the math is straightforward enough that there should be agreement all around (wishful thinking, I know).
“The right [expected return] number is probably 3%. Fixed income has negative real rates right now and will be a drag on returns. The math is not this easy, but in general, the expected return for equities is the inflation rate plus productivity improvements plus the expansion of the price/earnings multiple. For the past 30 years, an 8.5% expected return was reasonable, given +3%-4% inflation, +2% productivity, and +3% multiple expansion as interest rates plummeted. But in our new environment, inflation is +2%, productivity is +2% and given that interest rates are zero, multiple expansion should be, and I’m being generous, -1%.”
In not unrelated news, the City of Stockton (CA) has declared bankruptcy owing roughly $900 million to Calsters for its employee pensions — an amount that is far less than what it would be if the projected returns math were remotely accurate — and Gov. Jerry Brown has released a state budget suggesting a $29 million surplus for the fiscal year ending June 2013 and $1 billion in the next fiscal year on account of tax hikes, spending cuts and not an insignificant amount of fuzzy math, particularly as related to pensions.
Math is absolutely essential in our business. So is interpretive insight. One can surely agree with Prof. Frenkel that mathematical truths “will mean the same thing to anyone a thousand years from now” even while acknowledging that those truths will be misused and misinterpreted by politicians and probably even by investment “professionals” for at least that long.