Model Behavior

Dr. Kerry Back counts on equations to have plenty to say about people

Back The subject of economics has long intrigued Dr. Kerry Back. Since college, he has been captivated by the fact that people actually build models that can capture human behavior and explain day-to-day phenomena.“I’m interested in understanding things and economics is very powerful in explaining an important part of the world,” said Back.

Some may argue that standard models are inadequate to express how people really operate. But the underpinning of these theories, explained Back, is that most people act rationally and in their own self-interests. In economics, self-interest means maximizing profits and dollar values. “If you postulate that people behave rationally, you can predict their behavior to some extent and get useful mathematic descriptions, not with exact numbers, but in general terms of how people behave in certain settings.”

There is, however, the occasional surprise, with Back mentioning the recent financial crisis as an example. “People clearly did not understand how the world had changed with regard to mortgage backed securities and lending standards.”

Models have to be based on history, but Back said that not all elements of history were incorporated into the models, particularly when it came to lending standards. He found it a little surprising that sophisticated financial professionals were trading on models without adapting them to the changes in the environment in which they were operating.
 

Tipping Points


No matter what the models are telling him, Back is not one to give stock tips. In fact, he doesn’t think that anyone can really tell you a sure thing about an individual stock. But he’s certain of a few things. Over the past decade, there have been dramatic changes in the way stock exchanges operate. Technology is playing an increasingly significant role as executions are now measured in milliseconds, and those with data servers located at the exchanges have the speed advantage. But how exactly it will all evolve and what it will look like ten years from now—that’s speculation—interesting speculation for Back.

He’s intrigued by research studies that assess the performance of different investment strategies. Several of his students are involved in an independent project working on strategies to beat the market and manage money based on their strategies. While most of Back’s students will go into the corporate world, he believes that an understanding of investing is something every financial person in business should possess.

Back cites three varieties of generic investing models. The first is the “Warren Buffett” style; fundamental analysis, which is very hard to do and, since a lot of people try to do it, very competitive. The second is based on price trend, buying winners and selling losers. The third combines elements of the first two, with computers helping with calculations and making recommendations.

“Of course,” Back acknowledged, “you have to program the computer so you better find things that work!”

In the classroom, Back likes to tie things together with quantitative investment strategies, using historical returns and fundamentals to build algorithms. He encourages discussions about ideas, analysis of strategies, and how to implement them.

Each time Back teaches a class, he thinks of contributing factors in different ways and often gains new insights. His broadened perspective has caused him to consider writing a second edition of his well-received 2010 book, “Asset Pricing and Portfolio Choice Theory.” “There are some things I know now that I could do better after teaching the subject a few more times; things I should have added or done differently. You learn something new every day.”

Kerry Back holds the J. Howard Creekmore Chair in Finance at the Jones Graduate School of Business. Prior to joining the faculty in 2009, he was on the faculties of Northwestern University, Indiana University, Washington University in St. Louis, and Texas A&M University. He was senior associate dean and was named a university distinguished faculty member at Washington University in St. Louis. He earned a B.A. in economics at Western Kentucky University and a Ph.D. in economics at University of Kentucky. He teaches investments to MBA and Ph.D. students at the Jones School.