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A legend of finance
A Legend of Finance
ELTON
G. MCGOUN
There is an old joke in finance that goes as follows:’ A finance professor, an engineer, and a chemist were stranded together on a desert island with a large can of ham but no can opener. After various unsuccessful exercises in applied science by the engineer and the chemist aimed at opening the can, they turned in irritation to the finance professor, who all the while had been wearing a superior smile. “What would you do T”, they asked. “Let us assume we have a can opener,” came the unruffled reply.
What many do not know, however, is that there is much more to the story, and it may even be possible that the story is true. “That’s absurd!” exclaimed the engineer and the chemist in unison. “Of what possible use would it be to assume a can opener?’ “I know it sounds peculiar, but the most useful results in theoretical finance have come from this approach. I just happen to have a copy of an article by Milton Friedman that I keep with me for emergencies like this. It’ll explain it to you.” After a few hours punctuated by chuckles and puzzled expressions, the engineer and the chemist looked up. “There are some interesting comments here, but overall the article is very confusing. We’ve read it over three times and still don’t feel as if we understand it. Just what does this have to do with our situation?’ “It’s very simple! We need to open this can of ham.” said the finance professor. The engineer and the chemist nodded in assent. “Now in order to open this can of ham, we need a theory of how to open cans of hams. In fact, it would be desirable to have a theory of how to open cans in general.” The engineer and the chemist looked at each other. A thorough search had turned up no other cans of anything on the island. Nonetheless, they kept quiet and let the finance professor continue. “You both must agree that any theory of opening cans must make mention of a can opener, right?’ The faces of the engineer and the chemist showed that they did agree, but also that they were tiring of such apparently pointless questions. “This is a desert island, and our resources Elton G. McGoun International Coovriaht
l
Department
of Management,
Bucknell University,
Lewisburg,
PA 17837.
Review of Financial Analysis, Vol. 2, No. 2,1993, pp. 14%145.
0 1993 bv JAI Press. Inc.. All rights of reoroduction
ISSN: 1057-5219
in anv form reserved.
143
144
INTERNATIONAL
REVIEW
OF FINANCIAL
ANALYSIS
/ Vol. 2(2)
are limited; therefore, we will assume for convenience that a real can opener is of negligible importance and employ an assumed can opener instead.” The engineer could not keep quiet any longer. “But we have to really have some sort of can opener! What else could open a can?’ “We do have some sort of can opener. We have an assumed one. I know this seems unusual to you, but finance frequently encounters situations such as this. For example, many of our theories necessarily involve expectations regarding future prices; however, it would be very difficult, if not impossible, to come up with a theory that incorporated everyone’s individual expectations. We assume that everyone has the same expectations, even though we know that they do not. In fact if they did, no financial activity would ever occur. If the price of a stock were expected to fall, everyone who owned it would want to sell it, but no one who didn’t own it would want to buy it.” “And does this work?’ “As I said, the most useful results in theoretical finance have come from this approach.” The engineer was tempted to ask what these startling results were, but decided not to. The finance professor continued. “This is the point of Friedman’s article. The assumptions do not matter as long as the theory works. This was not just Friedman’s claim. Lawrence Boland2 identified it as the philosophy of instrumentalism. Theories and their assumptions are neither true nor false; they are merely instruments for generating predictions.” The engineer had never heard of instrumentalism, but had to agree that what counted was whether a theory worked. Instrumentalism sounded familiar to the chemist, but he didn’t think it had been an issue in the physical sciences for many years. He spoke up. “Even if you just assume a can opener and somehow the can is actually opened, wouldn’t you want to know why your theory worked? At least two of us would agree that it would be quite a surprise for an assumed can opener to open a real can.” “Are you interested in getting the can opened or not?’ asked the finance professor petulantly. The chemist did not hesitate to agree that was indeed his main concern. “Then let us assume a can opener and get on with it!” At this point the engineer and chemist, having plenty of spare time and nothing to lose, sat down beside the finance professor, and all three began diligently assuming a can opener. Four hours later nothing had happened. Overcoming his reluctance to incur the wrath of the finance professor, the engineer spoke up. “I don’t think it’s working.” The finance professor’s reply was surprisingly mild. “We must be absolutely certain that there are no errors in our observations.” So another four hours were spent examining the can from all different angles to ensure that it had not, in fact, opened. This time it was the chemist’s turn to speak. “I think we can be fairly sure that nothing is happening.” The response from the finance professor was unexpected. “This doesn’t surprise me. After all, our theory is only a first approximation. We must reexamine our assumptions.“The engineer and the chemist breathed a sigh of relief, but nearly choked when they heard the finance professor say, “We have been assuming that the can should be opened in the sun. Move it over in the shade of that palm tree and see what happens.” Another four hours later, nothing had. In fact after three days, a number of assumptions had been “relaxed,” as the finance professor called it. They turned the can upside down, laid it on its side, held it above their heads until their arms got tired, buried it in the sand, and finally even spun it around while the finance professor recited Kelvin’s mantra.3 Nothing worked.
A Legend of Finance
The patience
of the engineer
145
and the chemist,
which had
holding
finally disappeared. theory?’ asked the professor. replaced by a better We will continue haven’t gotten the can opened yet, you both have to admit that this theory has certainly been very useful in us think about can opening.” Many years later, when their skeletons were discovered, evidence that the professor had died first. He never about having been posthumously awarded Opening Practice (COPM).
NOTES 1. This version is from D. P. O’Brien (1974) via M. Blaug with a little modification. 2. Friedman’s position had been identified with instrumentahsm much earlier, but Boland’s was the first complete discussion of the matter. 3. “When you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind.”
REFERENCES O’Brien, D. P. 1974. Whither Economics? An Inaugural Lecture. Durham. University of Durham. Blaug, M. 1980. The Methodology ofEconomics. Cambridge: Cambridge University Press. Boland, L. 1979. “A Critique of Friedman’s Critics.” Journal ofEconomic Literature 17:2. Friedman, M. 1953. “The Methodology of Positive Economics.” In Essays in Positive Economics.
Chicago: University of Chicago Press. McCloskey, D.N. 1985. The Rhetoric ofEconomics.
Madison: University of Wisconsin Press.
ELTON
G. MCGOUN
There is an old joke in finance that goes as follows:’ A finance professor, an engineer, and a chemist were stranded together on a desert island with a large can of ham but no can opener. After various unsuccessful exercises in applied science by the engineer and the chemist aimed at opening the can, they turned in irritation to the finance professor, who all the while had been wearing a superior smile. “What would you do T”, they asked. “Let us assume we have a can opener,” came the unruffled reply.
What many do not know, however, is that there is much more to the story, and it may even be possible that the story is true. “That’s absurd!” exclaimed the engineer and the chemist in unison. “Of what possible use would it be to assume a can opener?’ “I know it sounds peculiar, but the most useful results in theoretical finance have come from this approach. I just happen to have a copy of an article by Milton Friedman that I keep with me for emergencies like this. It’ll explain it to you.” After a few hours punctuated by chuckles and puzzled expressions, the engineer and the chemist looked up. “There are some interesting comments here, but overall the article is very confusing. We’ve read it over three times and still don’t feel as if we understand it. Just what does this have to do with our situation?’ “It’s very simple! We need to open this can of ham.” said the finance professor. The engineer and the chemist nodded in assent. “Now in order to open this can of ham, we need a theory of how to open cans of hams. In fact, it would be desirable to have a theory of how to open cans in general.” The engineer and the chemist looked at each other. A thorough search had turned up no other cans of anything on the island. Nonetheless, they kept quiet and let the finance professor continue. “You both must agree that any theory of opening cans must make mention of a can opener, right?’ The faces of the engineer and the chemist showed that they did agree, but also that they were tiring of such apparently pointless questions. “This is a desert island, and our resources Elton G. McGoun International Coovriaht
l
Department
of Management,
Bucknell University,
Lewisburg,
PA 17837.
Review of Financial Analysis, Vol. 2, No. 2,1993, pp. 14%145.
0 1993 bv JAI Press. Inc.. All rights of reoroduction
ISSN: 1057-5219
in anv form reserved.
143
144
INTERNATIONAL
REVIEW
OF FINANCIAL
ANALYSIS
/ Vol. 2(2)
are limited; therefore, we will assume for convenience that a real can opener is of negligible importance and employ an assumed can opener instead.” The engineer could not keep quiet any longer. “But we have to really have some sort of can opener! What else could open a can?’ “We do have some sort of can opener. We have an assumed one. I know this seems unusual to you, but finance frequently encounters situations such as this. For example, many of our theories necessarily involve expectations regarding future prices; however, it would be very difficult, if not impossible, to come up with a theory that incorporated everyone’s individual expectations. We assume that everyone has the same expectations, even though we know that they do not. In fact if they did, no financial activity would ever occur. If the price of a stock were expected to fall, everyone who owned it would want to sell it, but no one who didn’t own it would want to buy it.” “And does this work?’ “As I said, the most useful results in theoretical finance have come from this approach.” The engineer was tempted to ask what these startling results were, but decided not to. The finance professor continued. “This is the point of Friedman’s article. The assumptions do not matter as long as the theory works. This was not just Friedman’s claim. Lawrence Boland2 identified it as the philosophy of instrumentalism. Theories and their assumptions are neither true nor false; they are merely instruments for generating predictions.” The engineer had never heard of instrumentalism, but had to agree that what counted was whether a theory worked. Instrumentalism sounded familiar to the chemist, but he didn’t think it had been an issue in the physical sciences for many years. He spoke up. “Even if you just assume a can opener and somehow the can is actually opened, wouldn’t you want to know why your theory worked? At least two of us would agree that it would be quite a surprise for an assumed can opener to open a real can.” “Are you interested in getting the can opened or not?’ asked the finance professor petulantly. The chemist did not hesitate to agree that was indeed his main concern. “Then let us assume a can opener and get on with it!” At this point the engineer and chemist, having plenty of spare time and nothing to lose, sat down beside the finance professor, and all three began diligently assuming a can opener. Four hours later nothing had happened. Overcoming his reluctance to incur the wrath of the finance professor, the engineer spoke up. “I don’t think it’s working.” The finance professor’s reply was surprisingly mild. “We must be absolutely certain that there are no errors in our observations.” So another four hours were spent examining the can from all different angles to ensure that it had not, in fact, opened. This time it was the chemist’s turn to speak. “I think we can be fairly sure that nothing is happening.” The response from the finance professor was unexpected. “This doesn’t surprise me. After all, our theory is only a first approximation. We must reexamine our assumptions.“The engineer and the chemist breathed a sigh of relief, but nearly choked when they heard the finance professor say, “We have been assuming that the can should be opened in the sun. Move it over in the shade of that palm tree and see what happens.” Another four hours later, nothing had. In fact after three days, a number of assumptions had been “relaxed,” as the finance professor called it. They turned the can upside down, laid it on its side, held it above their heads until their arms got tired, buried it in the sand, and finally even spun it around while the finance professor recited Kelvin’s mantra.3 Nothing worked.
A Legend of Finance
The patience
of the engineer
145
and the chemist,
which had
holding
finally disappeared. theory?’ asked the professor. replaced by a better We will continue haven’t gotten the can opened yet, you both have to admit that this theory has certainly been very useful in us think about can opening.” Many years later, when their skeletons were discovered, evidence that the professor had died first. He never about having been posthumously awarded Opening Practice (COPM).
NOTES 1. This version is from D. P. O’Brien (1974) via M. Blaug with a little modification. 2. Friedman’s position had been identified with instrumentahsm much earlier, but Boland’s was the first complete discussion of the matter. 3. “When you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind.”
REFERENCES O’Brien, D. P. 1974. Whither Economics? An Inaugural Lecture. Durham. University of Durham. Blaug, M. 1980. The Methodology ofEconomics. Cambridge: Cambridge University Press. Boland, L. 1979. “A Critique of Friedman’s Critics.” Journal ofEconomic Literature 17:2. Friedman, M. 1953. “The Methodology of Positive Economics.” In Essays in Positive Economics.
Chicago: University of Chicago Press. McCloskey, D.N. 1985. The Rhetoric ofEconomics.
Madison: University of Wisconsin Press.