In August 1952, the famous Benjamin Graham published an article in “The Analysts Journal” entitled, “Toward a Science of Security Analysis”. The article was sufficiently important to be republished in “The Financial Analysts Journal” in January 1995.

Ben Graham definitely did not say the security analysis was a “science”, but his comments implied that he would like to have the discipline move in that direction. He specifically made comparisons to the use of mathematical techniques in “actuarial science” and suggested that the practice of bond ratings was somehow scientific in nature.

By the time of the Crash of 2008, the emanations of “science” had cast a cloak of statistical pretense over the profession of securities analysis, as this abstract of the article, “The Statistics of Sharpe Ratios” (Andrew W. Lo, Financial Analysts Journal, July 2002), indicates:

The building blocks of the Sharpe ratio—expected returns and volatilities—are unknown quantities that must be estimated statistically and are, therefore, subject to estimation error. This raises the natural question: How accurately are Sharpe ratios measured? To address this question, I derive explicit expressions for the statistical distribution of the Sharpe ratio using standard asymptotic theory under several sets of assumptions for the return-generating process—independently and identically distributed returns, stationary returns, and with time aggregation. I show that monthly Sharpe ratios cannot be annualized by multiplying by √12 except under very special circumstances, and I derive the correct method of conversion in the general case of stationary returns. In an illustrative empirical example of mutual funds and hedge funds, I find that the annual Sharpe ratio for a hedge fund can be overstated by as much as 65 percent because of the presence of serial correlation in monthly returns, and once this serial correlation is properly taken into account, the rankings of hedge funds based on Sharpe ratios can change dramatically.

Now this sounds very “scientific”, especially if one has no knowledge of the scientific method and tends to believe in astrology. However, on examining the underlying assumptions of Modern Portfolio Theory (see: Fallacies of the Nobel Gods), under the harsh prism of the scientific method, problems with this approach become evident.

The above abstract seems to criticize the use of the Sharpe ratio, as a serious subject, but would a real scientific journal waste time evaluating the tenants of Medieval Astrology?

Many non-scientific practices are useful

We take our automobiles to the repair shop when they break down and are thankful for the skill and knowledge of an honest, professional mechanic who can get the machine running again. However, few would consider the auto mechanic to be a scientist.

Actuaries calculate the life expectancy of classes of individuals, based on mortality tables, but would not attempt to predict how long a specific individual will live (unless the subject is already falling from an airplane).

Much of security analysis has the purpose of determining whether the value of a security in the future will be higher or lower than the current value. A honest, competent security analysts will make such estimates based on careful and laborious study of relevant facts, and present conclusions properly hedged as to the general impossibility of predicting the future (in a non-scientific field of endeavor).

This is a valuable and useful service in itself and does not need to be dressed up in the pretense of science to become more useful.

In fact, scientific pretense can actually mislead investors (and analysts themselves).

Where pseudo-science harms investors

Leading up to the Great Crash of 2008, millions of hours of analyst time were wasted on drawing up tables with betas, Sharpe ratios, and other mathematical gimmicks that did not actually contribute to the understanding of an issue, but instead gave investors (and analysts) a false sense of security.

I would argue that this time (and many more hours) could have been better served digging up the facts about specific issues and examining operational and legal details under the cold light of common sense.

For example, would billions have been lost on auction rate securities if analysts had spent more time carefully researching the details of these issues and asked hard “what if” questions about the actual functioning of the Dutch Auctions on which their liquidity was based?

The principal problem with the pseudo-scientific approach to security analysis is that the methods often give analysts an excuse to avoid the much harder research work of going back to original sources of information and digging and digging for more facts until all relevant issues have been examined.

See: A security analysts greatest challenge: Laziness

Illustrations: Wiki Commons: The first illustration is from the Aurora consurgens, an illuminated manuscript of the 15th century in the Zurich Zentralbibliothek (MS. Rhenoviensis 172) — a medieval alchemical treatise that contains thirty-eight miniatures in watercolor.

In the first issue of the Financial Analysts Journal of January 1945 the question “Should Security Analysts have a Professional Rating” was debated.

Benjamin Graham (of Graham & Dodd fame) wrote in the affirmative.

Lucien O. Hooper (a founder of the Security Analysts Federation, and a vice president, director of research, and analyst of W.E. Hutton & Company) took the contrary point of view.

In time, Benjamin Graham’s point of view was adopted and the first CFA exams were held in June 1963.

However, some of Mr. Hooper’s initial objections are worth remembering.

Lucien Hooper’s objections

Although written 64 years ago, some of Mr. Hooper’s objections to the issuance of CFA credentials are relevant in light of the Crash of 2008.

He wrote:

Unless our employers, the investing public, or some government regulatory body force regimentation upon us, we earnestly desire to remain free from this unnecessary formalism.

It is not a matter of record that the Securities & Exchange Commission, the New York Stock Exchange, the Association of Stock Exchange Firms, or financial institutions have shown even an academic interest. It is not charged that the practices of the profession are honeycombed with abuses which need immediate and radical correction. Nor can it be contended that the mere establishment of the rating of Qualified Security Analyst (analogous to Certified Public Accountant) would make security analysts any more moral, more intellectually honest, less lazy, or more competent. Most analysts of experience will agree that laziness is our professions most virulent enemy.

So far as incompetence is concerned, every one of us knows that it more frequently is due to unwillingness to put in the required number of hours of work than to the lack of any formal education.

… the rating itself would be meaningless unless the rating authorities are able to enforce penalties. Lawyers are disbarred, doctors may have their licenses taken away, and a man who loses his C.P.A. rating often sacrifices an important part of his earning power.

No penalties for the lazy or incompetent

It is often recognized that failure of securities analysis and investment research was an aspect of the Crash of 2008. The analytical ability of the major credit rating agencies has been severely criticized by Congress. Failure of analysts to warn investors of problems with auction rate securities or insured municipal bonds have been noted.

As the Crash evolved, leading investment banks confessed that they were unable to value billions of dollars of securities held in their own portfolios.

This clearly indicates a problems in the profession of “security analyst”.

However, not a single credentialed analyst lost his or her certification. The SEC imposed no penalties on S&P or Moody’s for sloppy work. As Lucien Hooper indicated three generations ago, the CFA credential is largely meaningless, measuring neither competence nor commitment to professional responsibilities.

In fact, the credential is useful mainly in getting a job and as a marketing gimmick to dress up a firm’s portfolio of analysts.

It is also the source of substantial income for the CFA Institute that runs the certification program for fat fees.

Will there be changes in the profession of security analyst?

It is unlikely that there will be any significant reform of the credentialed profession of “security analyst”. As Mr. Hooper pointed out, the value of credentials for this profession is questionable. This weakness is compounded when there is no ongoing discipline associated with continued certification.

Furthermore, even if the CFA Institute were to raise standards of the profession, say by regular re-examinations or disciplinary actions for sloppy analysis (if that were even possible), there are many credential mills willing and able to churn out some combination of letters to attach to a person’s name to dress up a job resume.

Mr. Hooper seemed to suggest that anyone with above-average intelligence and a willingness to work hard at digging out information and thinking about the value of securities could do a better job than a credentialed analyst that succumbs to laziness, or whose time is devoted to trading securities or marketing chores, rather than research and analysis.

Security analysis requires not so much the possession of certain knowledge for which one might be tested, but rather the skill and determination to work hard at researching new areas, without predetermined conclusions or knowledge.

Between 1963, when the first CFAs were certified and the Crash of 2008, capital markets became increasingly complex, covering many more types of securities, institutions, jurisdictions, and instruments. Consequently, the work required to get the research job done properly today has increased considerably over the decades.

Furthermore, the traditional focus of a security analyst — financial statements and market prices — needs to expand to cover legal and operational aspects of complex instruments in exotic jurisdictions and circumstances, many, or even the majority, invented after certification may have been granted.

As indicated in the article, “British CFAs reject the Efficient Market Hypothesis“, elements in the curricula of analyst certification often fall behind the reality of today’s market.

Moving away from certification of knowledge

The lesson of the Crash of 2008 might be that future security analysts should be trained on-the-job, in actual research, with less emphasis on fixed curricula and studying for certification exams.

After all, if the structure and details of the market are constantly changing, with ever-increasing complexity, and if an analyst must be able, above all, to learn new things as one goes along, everyday, throughout his or her career, why not get right down to it, rather than waste time studying for exams on sterile topics?