“Phenomenological research and its potential for understanding financial models”

AUTHORS Michael S. Wilson

Michael S. Wilson (2011). Phenomenological research and its potential for

ARTICLE INFO understanding financial models. Investment Management and Financial
Innovations, 8(1-1)

RELEASED ON Friday, 15 April 2011

JOURNAL "Investment Management and Financial Innovations"

FOUNDER LLC “Consulting Publishing Company “Business Perspectives”

NUMBER OF REFERENCES NUMBER OF FIGURES NUMBER OF TABLES

0 0 0

© The author(s) 2019. This publication is an open access article.

businessperspectives.org
Investment Management and Financial Innovations, Volume 8, Issue 1, 2011

Michael S. Wilson (USA)

Phenomenological research and its potential for understanding

financial models
Abstract
Phenomenological research while relatively unused in finance research has much to offer. When we want to seek
“how” and “why” questions, we often are unfulfilled with quantitative financial models that rely on positivistic as-
sumptions. How people understand is context bound, and this factor needs to be explored more in finance research. The
financial meltdown in the United States demonstrated the need to better understand how financial managers made
sense of their world. This may have provided useful information for many stakeholders, especially those who relied too
heavily on “black boxes” that sought to identify law-like relationships in capital markets without recognizing the un-
predictable human behavior. This paper provides a description of why the meltdown occurred, and calls for the use of
increased interpretive research in understanding how finance is practiced in the area of executive compensation.
Keywords: phenomenological research, executive compensation, financial crisis inquiry commission, validity, modern
portfolio theory, capital asset pricing model, arbitrage theory, rational choice theory.
JEL Classification: ȼ10, ȼ53.
Introduction© i The financial crisis was avoidable. The financial
system and those in charge ignored warnings
Qualitative research methodologies have been mar-
and failed to question, understand, and manage
ginalized in many disciplines because more traditional
evolving risks.
approaches grounded in quantitative have held center
stage. A plausible explanation of qualitative methods i Widespread failures in financial regulation and
is the commonly held perception that qualitative meth- supervision devastated stability in the nation’s
ods are second-rate, and lack rigor and the objectivity financial markets.
of the quantitative approach (Enrich, 2005). Perhaps i Dramatic failures of corporate governance and
no other academic discipline subscribes to this ap- risk management at important financial institu-
proach more so than finance where the milestones in tions were key factors.
the field of valuation are shaped by quantitative judg- i A combination of excessive borrowing, risky
mental heuristic models that feature techniques for investments, and lack of transparency put the fi-
measuring risk and return. Esteemed economists like nancial system on a collision course.
Robert F. Engle, a 2003 Nobel Prize winner in eco- i Key government policy makers including the
nomics, advocate for more quantitative tracks in MBA Treasury Department, the Federal Reserve Board,
programs that feature more statistical models as the and the Federal Reserve Bank of New York were
solution (Engle & Granger, 2004). ill prepared for the crisis.
i There was a systematic breakdown in account-
However, the economic turmoil of 2008 is certain to ability and ethics.
spur research inquiries as to why many high risk
i Collapsed mortgage lending standards spread
securities were presumed to be safe. A number of
the crisis.
popular columns have attempted to explain the fail-
i Over-the-counter derivatives contributed sig-
ure of markets to properly price risk. Early evidence
nificantly to the crisis.
suggests financial models failed to keep pace with
the explosive growth in complex securities. Other i The failures of credit rating agencies were en-
failures were recognized as human failures in the ablers of the financial meltdown.
way that risk models were applied understood, and The failures of how financial models were applied
managed (Gerardi et al., 2008). are extensive. The market for credit default swaps
has been at the center of recent Wall Street banking
1. An avoidable crisis
failures. Many cite the failure of human factors in
The Financial Crisis Inquiry Commission was asked understanding the underlying financial models to
by the United States government to examine the fi- accurately assess the innovation associated with
nancial and economic crisis that affected the United credit default swaps. These instruments, originally
States and explain its causes to the American people. created to insure blue-chip investors against the risk
The conclusions of the commission included: of default, were rolled out to insure all types of fi-
nancial instruments, including pools of subprime
mortgage securities. These unregulated obscure
© Michael S. Wilson, 2011.
I would like to acknowledge the support and contributions of Dr. Michael G.
investments included an inherent counterparty risk
Sher and Dr. Kenneth Zapp. that seized up during the crisis (Lohr, 2008).
186
 Investment Management and Financial Innovations, Volume 8, Issue 1, 2011

The Commission described the interpretation of com- 2. Executive compensation

puter models that contributed to 45000 mortgage re-
The factors contributing to the financial meltdown
lated securities receiving AAA ratings. In 2006 alone,
included unresolved principle-agent problems.
Moody’s approved 30 mortgage-related securities
Compensation systems were based on beliefs that
every working day. Later over 8% were downgraded
goal congruence is promoted between managers and
(Financial Crisis Inquiry Commission, 2011).
stakeholders with incentive compensation. How-
The users of automated computer modeling also ever, managers’ ability to conceal implicit losses
failed to assess the lending risk on individual mort- creates a conflict between maximizing cash flow for
gage loans. In recent years the securitization of the the firm and managers’ own reputations and future
mortgage market with loans sold off and mixed into job prospects, creating an incentive to conceal im-
large pools of mortgage securities prompted lenders plicit losses (Kane, 1989).
to move increasingly to automated underwriting
systems without regard to human judgment of scru- By recognizing the inherent conflict, there has been
tinizing the creditworthiness of individuals. A sim- a change in the way that executive compensation
plistic view of quantitative models underestimated committees have been constructed recently. Legisla-
defaults of subprime borrowers as securitization tion, regulation, and public scrutiny have created a
became more prevalent, and lenders had less incen- more critical environment for these committees. The
tive to collect important soft information. A system- result has been a call for compensation committees to:
atic failure occurred as the creditworthiness of bor- 1. Move towards hiring independent consultants
rowers declined (Rajo, Seru & Vig, 2008). Other fail- and giving the committees authority to retain,
ures were noted by a recent paper by Federal Reserve monitor, and fire consultants independent of
economists (Gerardi et al., 2008) who found that ana-
management.
lyst models could predict that a subprime meltdown
2. Mitigate risks to create incentives for employees
would follow a 10-20% drop in real estate prices;
to avoid excessive risks.
however the analysts failed to recognize the prob-
3. Promote transparency and accountability by
ability of a drop in real estate prices. The analysts
advocating for “Say on Pay” which includes a
responsible for the models assumed that nominal
housing prices would not decline because overall nonbinding shareholder vote on executive com-
declines had not occurred in decades, yet there have pensation.
been many regional declines. 4. Benchmark pay through audits of compensation
strategies on an annual basis to keep abreast of
Some of the practices bordered on fraud, or were out- trends laws, and regulations.
right fraud. Lots of firms were lending money to peo- 5. Strike a balance between management’s expec-
ple who shouldn’t have been borrowing it. A simple tations and shareholder value to reflect recruit-
measure of sanity in housing prices is the ratio of me- ment and retention and to communicate com-
dian home prices to income, historically the measure is pany values.
around 3 to 1. In Los Angeles, it was 10-1 and Miami
it was 8.5 to 1. In Bakersfield, CA a Mexican straw- The compensation committee’s role has increased in
berry picker with an income of $14,000 was lent every complexity, and will likely increase in coming
penny to buy a house for $720,000 (Lewis, 2008). years. Compensation committees should focus on
the tools they need to design and monitor effective
The heavy reliance on financial models is rooted in
compensation programs to fairly compensate man-
the physical sciences. Physics, for example, has had
astonishing success at predicting the future behavior agement and protect shareholder value (Randolf-
of material objects and inspired most financial mod- Williams, 2010)
eling (Derman & Wilmott, 2009). In academia the 3. A case for phenomenology
focus is often on problems that can be solved,
proved, and published. In science the models derive In the midst of these challenges, executive compen-
from particle flows which conform to the neat, crisp sation committees could benefit by recognizing that
laws of physics (Lohr, 2008). However in the real finance is often the practice of universal laws of
world of finance, there are no fundamental laws, and economics, and the Austrian School of Economics
if there were, there is no way to run repeatable ex- has much to offer. The central claim of Austrian
periments to verify them, suggesting a false sense of Economics is the logic of human action is an immu-
precision (Derman & Wilmott, 2009). As one quant table feature of the world, and this approach help to
star put it, to confuse the model with the world is to understand the relationship between action and re-
embrace a future disaster driven by the belief that sults, or cause and effect relationships. The goal of this
humans obey mathematical rules (Lohr, 2008). approach is to understand the world as it is.

187
Investment Management and Financial Innovations, Volume 8, Issue 1, 2011

Interpretive research has potential to become a more 4. Theoretical financial milestones

attractive research methodology for use in manage-
A brief review of the major financial theories is
ment related research. An interpretive study can be
organized into two categories to identify areas
extended in different directions to meet the desire to
where theory and practice diverged. Important
develop deeper understanding of experiences. An
Seminal theories that attempted to explain how the
interpretive design is focused on the meaning of
overall markets operate are the foundation of fi-
human interactions and exploring individuals’ inter-
nance models.
pretations and beliefs (Denzin & Lincoln, 1994).
Phenomenological research aims to understand phe- These valuation models are organized in the way in
nomena in their pure, pre-reflective form, and gain which they evolved to recognize arbitrage opportu-
an in-depth understanding of the participants’ experi- nities. Arbitrage is one of the most important fun-
ence (Courtenay, Merriam & Reeves, 1998) yielding a damentals of financial models. It typically defines
deeper understanding of complex phenomena within the process of taking advantage of a price difference
an organizational context. between two or more markets. These seminal works
are often referenced in explaining how investments
Compensation committees could benefit from de-
are valued. The following models were summarized
veloping a deeper understanding of how financial
models are being used by managers to enhance from the wellknown theories from the web, and are
shareholder value and promote goal congruence. common to most introductory finance textbooks
Phenomenological studies start with a question (Finance Maps of the World, 2008).
about the meaning of a phenomenon like, what is it 4.1. Modern portfolio theory. Modern portfolio
like to use data from your model to make transac- theory (MPT) proposes how rational investors will
tions? Typically, the experiences of a few people use diversification to optimize their portfolios, and
constitute a phenomenological inquiry (McClelland, how a risky asset should be priced. The basic con-
1995). Texts are found in diaries, journals, or other cepts of the theory are Markowitz diversification,
sources, or they are created from interviews, discus- the efficient frontier, capital asset pricing model, the
sions, or other interactions that represent lived ex- alpha and beta coefficients, the capital market line
periences. A dialog is created between the research and the securities market line. MPT models an as-
and a text with the researcher seeking an authentic
set’s return as a random variable, and models a port-
telling of the experiences and what they mean from
folio as a weighted combination of assets so that the
the perspective of the participant. Themes are de-
return of a portfolio is the weighted combination of
veloped from the texts to express the essence of the
experience being studied. Lived experiences of the the assets’ returns. Moreover, a portfolio’s return is
research participants and research literature are a random variable, and has an expected value and a
woven together to express a theme. Because theme variance. Risk, in this model, is the standard
development is a subjective endeavor, bias as we un- deviation of return.
derstand it in empirical studies is not a concern. The 4.2. Capital asset pricing model. The model was
strength of the argument is the basis for validity developed upon the earlier theory founded by Harry
(McClelland, 1995). The first assumption related to Markowitz known as the mean-variance portfolio
phenomenology is that it entails turning to experience theory. The capital asset pricing model (CAPM) is
as we live it rather than as we represent it with theo- concerned with finding out the suitable return rate of
ries. It attempts to find voices and expressions that an asset when the asset is about to become a part of
reveal meaning that goes beyond logic, prediction, an existing diversified portfolio. The capital asset
control, and cognition.
pricing model is also concerned with the market risk
The power of this type of study would be to demon- and sensitivity of an asset’s return regarding these
strate how important financial theories are being ad- risks. At the same time, CAPM also considers return
hered to, or not. from a particular asset that is theoretically denoted
Imagine if phenomenological studies were used to as risk free. CAPM categorizes the risk related to
investigate the lived experiences of financial ana- the portfolio in two different types, systematic risk
lysts. An interpretive researcher with a finance and specific risk. The systematic risk denotes the
background could tailor questions to inquire about risk factor related with holding the market portfolio
probability assumptions and illusions of validity that because the fluctuations in the market influence the
were inherent in the models relied on during a pe- individual assets also. Unsystematic risks, or specific
riod of irrational exuberance. The result could have risk, represent the failure to diversify a portfolio.
been a deeper understanding of the lived experi- CAPM holds that all those investors who are taking
ences and answers to how these practices coincided systematic risks are compensated by the market-
with important financial theories. place. On the other hand, the marketplace never
188
 Investment Management and Financial Innovations, Volume 8, Issue 1, 2011

compensates those investors for taking specific risk. action parallel to each other, the rational choice
The prime reason behind this is that there is a cer- theory considers reward and punishment as benefit
tain process through which the specific risks can be and cost respectively and the theory holds that the
minimized. A portfolio consists of different individ- human action is dominated by their desires of get-
ual assets and each one of these assets implicates ting good rewards.
specific risk. By proper use of diversification the
5. The illusion of validity
specific risks can be reduced.
Many financial models exude confidence with little or
4.3. Arbitrage pricing theory. The arbitrage pric- no regard for factors that limit predictive accuracy
ing theory offers a testable alternative to the well- (Behavioral Revolution, 2008). This unwarranted
known capital asset pricing model because empirical confidence, that is produced by a good fit between
research cast doubts on the single factor explaining the predicted outcome and the input, information
returns. An important figure in this theory was may be called the illusion of validity. There is a
Stephen A. Ross who offered a testable alternative tendency to predict the outcome that best repre-
to the well-known capital asset pricing model sents the data without regard for prior probability.
(CAPM) which is the basis for modern portfolio The internal consistency of a pattern of inputs is a
theory. Ross found at least three and probably four major determinant of one’s confidence in predictions
factors in explaining returns (Roll & Ross, 1990). based on these inputs. People are more likely to ex-
The arbitrage pricing theory addresses the general press confidence in predicting stock price of a com-
theory of asset pricing. Proper asset pricing is nec- pany that has consistent earnings than in predicting
essary for the proper pricing of shares. The arbitrage the stock price of a company with earnings volatil-
pricing theory states that the return that is expected ity. Highly consistent patterns are most often ob-
from a financial asset can be presented as a linear served when the input variables are highly redun-
function of various theoretical market indices and dant or correlated. Hence, people tend to have great
macro-economic factors. An asset’s return is sensi- confidence in predictions based on redundant input
tive to changes in the factors, and the sensitivity to a variables (Tversky & Kahnamen, 1982). However, an
particular factor is represented by a coefficient. elementary result in the statistics of correlation asserts
that, given input variables of stated validity, a pre-
4.4. Rational choice theory. Rational choice theory
diction based on several inputs can achieve higher
is used to understand the social and economic be-
accuracy when they are independent of each other
haviors of the individuals. It is used in a number of
than when they are redundant or correlated. Thus
academic subjects like Microeconomics, Political
redundancy among inputs decreases accuracy even
Science, Sociology and many more. The application of
as it increases confidence, and people are often con-
the term rationality varies with the subject. Many other fident in predictions that are quite likely to be of the
economic theories are concerned about the mechanism mark (Tversky & Kahnamen, 1982). Many analysts
of the market that enables the production and distribu- fail to recognize the regression toward the mean that
tion of goods. But the rational choice theory is exten- naturally occurs. Some may fail to recognize the
sively used in applying the same principles that are regression to the mean where it is bound to occur.
used by other economic theories to understand interac- Or in some cases, they may recognize the regression
tions that include resources like prestige, time and but invent spurious casual explanations for it (Tver-
many more. According to the rational choice theory, sky & Kahnamen, 1982).
human beings are prompted by their own goals and
preferences. Human actions are regulated primarily by 6. Behavioral finance
the information regarding the conditions under which a One response to these weaknesses is to promote the
particular individual is going to work and would try to concept of behavioral economics and finance, which
achieve his or her goal. It is almost impossible for the apply scientific research on human and social,
human beings to get whatever they desire. Choice of cognitive and emotional factors to better understand
goals along with the selection of a proper method to economic decisions and how they affect market
reach the previously set target is very important in prices, returns and the allocation of resources. The
the domain of rational choice theory. According to fields are primarily concerned with the bounds of
rational choice theory, each and every kind of social rationality of economic agents. Behavioral models
contact or social interaction is treated as a method of typically integrate insights from psychology with
social exchange. If the action is economic, the term neo-classical economic theory. Behavioral models
“exchange” is used to denote the exchange of cer- integrate insights from psychological research into
tain goods and various services, but if the exchange economic science, especially concerning human
is social, interchange of behaviors and approvals judgment and decision-making under uncertainty
takes place. Again, to keep the social and economic (Behavioral Revolution, 2008).

189
Investment Management and Financial Innovations, Volume 8, Issue 1, 2011

Behavior of Finance recognizes that we are influenced that rational decisions tended to converge quickly but
by others in almost every activity perhaps due to a were idiosyncratic and fragile like the theorists
herd instinct, or from a contigious emotional response such as Hirschleifer and Teoh (2003) suggested, but
to stressful events. The basis of this research explores these weaknesses in financial models were not recog-
whether irrational investor errors cause market mis- nized by practioners and compensation committees.
evaluation of assets (Hirschleifer & Teoh, 2003). Conclusion
The purely rational approach to executive compensa- There is an important place for phenomenological
tion was likely influenced by the psychology of other and other interpretive methods of research in fi-
compensation plans. Underlying the theory of be- nance. Interpretive research in the field of finance
havioral finance is the recognition that it is harder has much to offer stakeholders interested in under-
to actually make money than ivory tower theorists standing how financial theory is practiced. A re-
claim (Hirshleifer, 2001). Phenomenological re- searcher with a solid understanding of key financial
search may help to recognize that there are pat- theories could use interpretive methods to illuminate
terns of convergent behavior and fluctuations in compensation practices that are inconsistent with
capital markets that do not make immediate sense theory, or more importantly identify those practices
in terms of traditional economic models. It appears that encourage inherently risky behavior.
References
1. Brooks, D. (2008). The behavioral revolution. The New York Times, October 27, pp A. 31.
2. Coomer, D.L., & Hultgren, F.H. (1989). Considering alternatives: an invitation to dialog and question. In D.L.
Commer & F.H. Hultgren (Eds), Alternative modes of inquiry. Washington DC: American Home Economics As-
sociation, Teacher Education Section.
3. Courtenay B.C., Merriam, S.B. & Reeves, P.M. (1998). The centrality of meaning-making in transformational
learning: how HIV positive adults make sense of their lives, Adult Education Quarterly, 48 (2), pp. 65-84.
4. Denzin, N.A. & Lincoln, Y.S. (1994). Introduction: entering the field of interpretive research. In N.K. Denzin and
Y.S. Lincoln (Eds.), Handbook of interpretive research (pp. 1-17). Thousand Oaks, CA: Sage publications.
5. Derman, E. & Wilmott, P. (2009). Perfect models imperfect world. Businessweek, January 12, pp. 59-60.
6. Finance Maps of World. Electronic references to financial models. Retrieved December 3, 2008, from
http://finance.mapsofworld.com/finance-theory/.
7. Engle and Granger win Nobel Prize (2004). Biz Ed, January/February, pp. 8.
8. Enrich, L. (2005). Revisiting phenomenology: it’s potential for management research. In proceedings challenges
or organizations in global markets. British Academy of Management Conference, pp. 1-13.
9. The financial crisis inquiry report (2011). The final report of the national commission on the causes of the finan-
cial and economic crisis in the United States. Washington DC: U.S. Government Printing Office.
10. Gerardi, K., Lehnert, A., Sherlund, S.M. & Willen, P. (2008). Making sense of the subprime crisis. Prepared for
the Brookings Panel on Economic Activity.
11. Giorgi, A. (1997). Theory, practice, and evaluation of the phenomenological method as a interpretive research
procedure, Journal of Phenomenological Psychology, 28 (2), pp. 235-260.
12. Hirshleifer, D. (2001). Investor psychology and asset pricing. The Journal of Finance, 56 (4).
13. Hirshleifer, D., Teoh, S.H. (2003). Herd behavior and cascading in capital markets: a review and synthesis, Euro-
pean Financial Management, 9 (1), pp.25-66.
14. Hultgren, F.H. (1989). Introduction to Interpretive Inquiry. In F.H. Hultgren & D.L. Coomer (Eds). Alternative modes of
inquiry. Washington D.C., American Home Economics Association, Teacher Education Section, pp. 283-290.
15. Kane, E.J. (1989) Changing incentives facing financial-services regulators, Journal of Financial Services Re-
search, 2, (3), pp. 265-274
16. Lewis, M. (2008). The End. Portfolio.com, December.
17. Lohr, S. (2008). In modeling risk, the human factor was left out, The New York Times, November 4, pp. B1.
18. McClelland, J. (1995). Sending children to kindergarten: a phenomenological study of mother’s experiences, Fam-
ily Relations, 44 (2).
19. Polkinghorne, D. (1989). Methodology for the human sciences: systems of inquiry. Albany, NY: University of
New York Press.
20. Randolf-Williams, E. (2010). The changing role of the compensation committee: five areas compensation commit-
tees should be addressing in 2010 and beyond, Benefits Law Journal, 23 (2), pp. 17-27.
21. Rajon, U., Seru, A. & Vig, V. (2008). The failure of models that predict failure: Distance, incentives and defaults.
University of Chicago Graduate Business School Research Paper 08-19.
22. Roll, R., Ross, S.A. (1980). An empirical investigation of the arbitrage pricing theory, The Journal of Finance, 35 (5).
23. Thorton, M. (2001). Austrian economics: new applications, Austrian Economics Newsletter, 21 (2).
24. Tversky, A. & Kahnamen, D. (1982). Judgement under uncertainty. In Kahnamen, D., Slovic, P., & Tversky, A.
(Eds) Judgment under uncertainty (2nded). Cambridge, MA: Cambridge University Press.
25. Van Manen, M. (2001). Researching Lived Experience. Human Science for an Action Sensitive Pedagogy (2nd ed.).
Alberta, Canada: Althouse Press.
190