Formula for fiscal prudence in the face of a pandemic

Author: 
Jennifer Rathwell

A crisis of any kind generally makes investors reach for the panic button. Royal Roads Assoc. Prof. Hany Fahmy wanted to get to the bottom of that behaviour and examine the age-old question of “buy or hold?” when investor irrationality runs rampant through the markets.

“In finance there are two schools of thought,” says Fahmy, who is the finance intellectual lead at the Royal Roads University School of Business. “One that markets are efficient, and another that believes investors are irrational. So once there is a tweet from Trump or an economic shock, when they read the news, they start to behave irrationally and rebalance their portfolio and this will cause the market to fluctuate.”

Overreaction to financial news can cause investors to try revise their portfolios quickly, and if every investor does the same in the face of a crisis like COVID-19, there is a real risk of the financial markets collapsing. While this may seem like an intuitive idea, Fahmy’s theory set out to be the first to prove, mathematically, that these drastic changes cause markets to trend down.

“I wrote a paper that can explain the drastic change in the financial market after the pandemic, and I showed that irrational investors following this news ended up revising their portfolios earlier and this caused financial markets to trend down,” says Fahmy.

Neuroscience, a love of “pure mathematics” and the germ of an idea that Fahmy just couldn’t let go came together in his work, which builds on the Nobel prize-winning Markowitz Theory, which economics students will know, and the rest of us hope our investment advisor is familiar with. The original theory has to do with looking for the best return on investment – Fahmy’s theory advances to look at time in the market.

“Markowitz’s theory; call it MV, where M stands for mean and V stands for variance, looks at how investors can make the maximum average/mean return of a portfolio or, equivalently, minimum risk/ variance,” he explains. “My own theory extends Markowitz to add time (T) to the equation; basically, adding T to MV.

“The MVT extension considers the construction of an investment portfolio as an activity like playing soccer, watching a play, or sleeping; it is a combination of goods and activity duration time,” Fahmy says.

“When you build a portfolio, you have a bunch of assets (goods) and the activity duration time (the duration of the portfolio) – is there really an optimum time for you as an investor to choose to revise or rebalance your investment? The MVT formula provides an answer to this question.”

What the formula shows is that optimum duration depends on investors’ degree of irrationality, news intensity, and their expectations. So, what is the best duration strategy? Fahmy shows that long-term trading strategies are more profitable for rational investors under perfect information.

It’s now a proved theory, but Fahmy says he is most excited that it means the theory must now be tested by savvy investors and academics and applied to business. As Fahmy sees it, there is the intuitive, real-world part of math, there are the equations, and then there’s what they can do working together.

“If you know both, you’re lethal,” he says. “You know it inside and out.”

Read the full paper in the Journal of Economics and Business.