Book Review: Heterodox Investment Theory


Heterodox Investment Theory: Stochastic Predictability and Uncertainty. 2017. Thomas Pistorius.

Investment analysts are constantly looking for ways to better understand and predict the financial markets. The most common approach is to use a wide range of statistical tools to build models of investment returns, but is this the correct approach for investment theory? In Heterodox Investment Theory: Stochastic Predictability and Uncertainty, Thomas Pistorius, an investment and financial analyst for more than two decades, challenges this approach. The book is based on Pistorius’s PhD dissertation, “The Rhetoric of Investment Theory,” at the Erasmus Research Institute of Management. His objective is to challenge modern investment theory and its use of statistics as the dominant tool of decision making. The title of Pistorius’s dissertation shows how much he was influenced by the work of Deirdre McCloskey, who challenged much of the economic mainstream’s use of mathematics and statistics. Pistorius is trying to do for investment theory what McCloskey did for economics — that is, open up a dialogue on some of the tools and tenets of modern investment theory.

Pistorius begins with a history of finance that dates back to the thirteenth century. He continues his discussion of investment theory by providing a thorough review of risk, uncertainty, and investment models by examining the works of many mainstream financial economists, as well as mathematicians and economists who are not commonly referenced in the field of investments, such as John Maynard Keynes, Ludwig von Mises, Benoit Mandelbrot, and Deirdre McCloskey. Along the way, Pistorius discusses how finance became a part of economics and the field we now know as financial economics. Rather than simply providing a standard review and criticism of previous investment models, the author takes a different approach from most books by drawing on history, philosophy, rhetoric, and culture for his analysis.

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For Pistorius, modern investment theory begins with Harry Markowitz’s seminal work on portfolio theory and the behavior of an optimizing investor. The biggest problem Pistorius sees in investment theory is that in these models, such variables as expected return and standard deviation are predictable. The author surveys a number of popular investment textbooks and notes that none of them reference Frank Knight, who first distinguished between risk and uncertainty, and others, such as Keynes and von Mises, who also examined uncertainty in economics. Much of the book provides nonmathematical critiques of mainstream investment theories, such as the capital asset pricing model (CAPM), arbitrage pricing theory, the Black–Scholes option pricing theory, efficient markets, and behavioral finance.

Pistorius points out that rather than predicting financial markets as modern investment theory seeks to do, many of the alternative models presented in the book seek to explain or model financial markets. Some of these approaches, such as behavioral finance, have gained much mainstream acceptance, whereas others, including bubble theory and Mandelbrot’s fractal finance, remain more on the fringes of the field. One of the author’s key points is that science is not only about prediction but also about understanding. If understanding financial markets is one of the important goals of investment theory, then a number of areas of financial research provide competition for modern investment theory.

Heterodox Investment Theory is a thought-provoking book that challenges the profession to move away from using statistical models as the dominant tool of decision making and to relegate statistics to a supportive role. Pistorius’s approach to investment theory through the lens of history, philosophy, rhetoric, and culture is likely to make the book a difficult read for most finance professionals. Readers are more likely to feel that they have returned to their undergraduate days studying Aristotle rather than their days in business school reading the Financial Analysts Journal or the Harvard Business Review. Investment professionals who are intrigued by the topic but who may be deterred by the author’s approach to presenting these topics might wish to begin with his Journal of Organizational Change Management article.

The strength of Heterodox Investment Theory is that it reminds investment professionals that under Knightian uncertainty, statistics should be supportive rather than dominant in decision making. The problem is that although many investment professionals likely support this tenet, some of the alternative approaches discussed in the book can be difficult to incorporate in the decision-making process. The book’s greatest contribution is to encourage investment professionals to look beyond the standard investment models that are taught in business schools and the statistics underlying the theories and to consider alternative models that may enhance their understanding of financial markets. Those who are comfortable with the jargon of philosophy and rhetoric will likely find this an interesting book that opens up their minds to new modes of thinking.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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Ronald L. Moy, CFA

Ronald L. Moy, CFA, is associate professor of finance at Tobin College of Business, St. John’s University, Staten Island, New York.

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