HOUSTON, WE DON’T HAVE A PHYSICS PROBLEM

The past week has been full of coverage of Man’s flight to the Moon.

As the Apollo 11 astronauts awaited lift-off their demeanour was outwardly calm, but the biometric readings told a different tale. Their courage was astonishing, of course, but what made them confident of reaching their objective was the science – and the physics that supported that science.

The landing on the moon was the culmination of a long series of calculations based on the immutable laws of physics. But because fifty years ago computing power was in its infancy almost all of these calculations had to be done by hand, with a slide rule, a pencil and the firm structures of physics to guide them.

Those astronauts knew that physics was on their side; training, skill and courage did the rest.

For investors the laws we follow are based on capitalism and its raw power. But unlike the laws of physics, the laws of capitalism are constantly evolving and some of the most basic principles were only developed very recently: In 1952 Harry Markowitz discovered the power in diversification in what is now known as “Modern Portfolio Theory”. In 1960 Bill Sharpe published his paper on the Capital Asset Pricing Model, and it was only in 1992 that Fama and French began uncovering the “Risk Factors” built into most portfolio construction tools.

Finance theory is a far younger and much less precise discipline than physics – it’s part art and part science – but what makes it fascinating is the additional calculations that human behaviour adds to it. We know that events outside our control can change the investment landscape. But even in these times of change and upheaval it is still possible to have faith in the laws of capitalism.

Investors don’t need the courage of astronauts, but they do need to trust in the basic underlying principles that guide us to our target; the profit motive, group behaviour, history.
Both investing and exploration requires planning, analysis and courage. When things don’t go quite according to plan, we need to trust some greater power – physics or capitalism – but it’s still human miscalculation that is the greatest challenge.