EUROPE - Modern portfolio theory and practice are failing institutional investors, argues a new paper from the 300 Club, the group of 10 investment professionals formed to raise awareness of the potential impact of current market thinking.

'The Death of Common Sense' describes how the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH) contributed to the 2008 crash, yet continue to shape the psyche of financial investors and policymakers even though no longer tenable.

The paper traces the origins of these theories to the 1950s, when the world of investment was identical to what it had been 100 years ago, according to Professor Amin Rajan, chief executive at Create Research, the independent global forecasting centre, and the paper's author.

"Then Harry Markowitz, the pioneer of modern investment theory, pointed out that investing was taking a bet on an unknown future, and that investors had to look at risk as well as returns," Rajan said.

This view inspired the creation of the CAPM and EMH, both of which have since dominated portfolio theory.

"But they have led to the inference that markets are efficient and that it's impossible to beat the market, which is simply untrue," he said.

"If markets were always valuing assets properly, you wouldn't get active managers beating the markets from time to time."

He said this view had led to the belief that there was no point in too much regulation because "the invisible hand of the market is more powerful than the visible boot of regulation".

Indirectly, according to the paper, the EMH turned the art of investing into a science, from judgement calls to mechanical formulas.

Modern innovations such as derivatives, shorting and high-frequency trading were justified as the only means to beat the market through clever mousetraps.

"But the main outcome has been systemic risks, product complexity and higher charges," Rajan said.

Ultimately, the result was the massive fault in the market between 2002 and 2008, with excess liquidity in the global system and no chance for markets to correct.

And in 2008, the US sub-prime crisis wiped out $15trn (€11trn) in asset values, with 15 years of capital gains erased over 15 months.

Rajan said: "Our main conclusion is that neither the CAPM or the EMH have much empirical support. They work until they don't work. Both have undergone significant refinements to the point where their much-publicised inferences are no longer tenable.

"CAPM and EMH promoted a worldview detached from the on-the-ground reality. For a long time, they rode on the back of the strong pro-market, anti-regulation sentiment unleashed by the Thatcher-Reagan era in which faith mattered more than facts."

The paper does not set out a blueprint for change, but is intended to stimulate debate among market players.

"The aim is to influence people at the client end," Rajan said.

The paper is the first of a planned series to include dynamic asset allocation, manager selection and client engagement.

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