Is finance an art or a science?

By Chris Gallant AAA
A:

The short answer to this question is "both". Finance, as a field of study and an area of business, definitely has strong roots in other scientific fields such as statistics and mathematics. Furthermore, many modern financial theories resemble scientific nomenclature. However, there is no denying the fact that the financial industry also includes non-scientific elements that liken it to an art. For example, it has been discovered that human emotions (and decisions made because of them) play a large role in many aspects of the financial world.

Modern financial theories, such as the Black Scholes model, draw heavily on the laws of statistics and mathematics found in science; their very creation would have been impossible if science hadn't laid the initial groundwork. Also, theoretical constructs such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH) attempt to logically explain the behavior of the stock market in an emotionless, completely rational manner, wholly ignoring elements such as market sentiment and investor emotions.

And while these and other academic advancements have greatly improved the day-to-day operations of the financial markets, history is ripe with examples that seem to contradict the notion that finance is a science. For example, stock market crashes such as the Oct 1987 crash (Black Monday), which saw the Dow Jones Industrial Average (DJIA) fall more than 22% and the great 1929 (Black Thursday) crash that spurred the Great Depression, are not suitably explained by scientific theories such as the EMH. (For further reading, see The Biggest Market Crashes.)

In addition, the track records of investors as a whole have shown that markets are not entirely efficient and, therefore, not entirely scientific. Studies have shown that investor sentiment appears to be mildly influenced by weather, with the overall market generally becoming more bullish when the weather is predominately sunny. Other phenomena include the January effect, which exposes the pattern of stock prices falling near the end of the calendar year and rising at the beginning of the next. (To learn more, see Taking A Chance On Behavioral Finance.)

Furthermore, certain investors have been able to consistently outperform the broader market for long periods of time, most notably famed stock-picker Warren Buffett, who at the time of writing is the second-richest American, his wealth largely built from long-term equity investments. The prolonged outperformance of a select few investors does much to discredit the EMH, leading some to believe that to be a successful equity investor, one needs to understand the science behind the number crunching and the art behind the stock picking exhibited by such investors as Warren Buffett. (For more about the "Oracle of Omaha", see Warren Buffett: How Does He Do It? and What Is Warren Buffett's Investing Style?)

The debate continues as to whether the field of finance is more accurately characterized as an art or a science - more than likely, it's a little bit of both.

For more detail from both sides of the debate, try reading Understanding Investor Behavior.

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