When the academic world of CFA met the practical world of investing - Part I

This summer, I appeared for Level 3 exam of Chartered Financial Analyst Institute, along with 35 odd thousand candidates, across the globe. With pass rates hovering around 50% for each level, the chances of any candidate clearing over the final frontier is only slightly better than 10%.

Yet, in the last weeks of August, I joined a select group of talented, dedicated investment professionals when the results finally did come out. I cleared the last level of CFA and earned the right to attach the famed 3 lettered suffix after my name, subject to some conditions.

Only after the dust settled, I could gather a perspective when I stepped back and took in the big picture. Interestingly some starting epiphanies popped. Owing to the extremely short attention span of homo-conexius (the always connected man- modern day internet surfer) I will be dealing with these ideas in one post at a time

#1 Qualitative vs Quantitative (aka Mental Models trump Formulas every day)

The world of academics excels in providing a quantitative view of investing. It is not much of a surprise, since incorporating a “qualitative” view will require a huge amount of effort from the instructor as well as opening up chances of allegations of unfair play.

But the real world of investing seldom moves in a set, predefined fashion. It is messy, it is doubt inducing and decision making has to be made under imperfect information. But the completeness of information aside, academic world often fails to take in the second order effects of their own actions.

The new investment professional is never really going to make money, if he practices what he has learned in the curriculum.

For the sake of simplicity, let’s do indeed assume that the formulas and the rulesets that academics propose for valuation are accurate and widely practiced. What happens to the ‘alpha’ as a result?

Market is close to perfect most of the times, and for the most part the practitioners are going to “arbitrage” away any advantage due to those formulas and rule-sets.

The startling conclusion is - the incremental investment professional (minted fresh every year) is never really going to make money, if he is to practice religiously what he learned in the curriculum.

Instead, the real advantage lies just beyond the thin veil of deterministic formulas. Into the world of ideas – subjective lessons drawn from the sum total of human knowledge. These ideas can be readily used as guiding posts to navigate a world of unknown unknowns.

These ideas, can range from popular proverbs “there is never one cockroach in the kitchen” to, social observations like, “what a wise man does in the beginning, fool does at the end”, to even insights from mathematical ideas like “it is not in the interest of a predator to make its prey extinct” [Lotka-Volterra models] Bring them together, added with a smattering of common sense, business knowledge to navigate the world of finance and we have enough gunpowder to make successful investments.

Investing, like war, is just life, but compressed

Experienced practitioners use these “mental models” to assess the business potential of companies, to judge people at their helm, to guide even their own behavior. These lessons unfortunately are never taught in any curriculum. They are taught in the book of life. Investing too, because like war, it is life, but compressed.