Counterpoints to financial engineering

It includes traditional market efficiency arguments against active management, such as Bill Sharpe's arithmetic (see Active Portfolio Management). And even if it is possible to beat the market, and notwithstanding the fact that past performance should not be the sole criterion for judging investment managers, the riskiness of active strategies can be very different from passive strategies (see Indexing). Such risks do not necessarily average out over time, and investors' risk tolerance should be part of the process of selecting an investment strategy to match their goals (see Investment Policy).

A second counterpoint is the set of arguments against quantitative investing, and notably its reliance on backtesting and data mining (see Quantitative Investing). Engineering, by the very nature of its development and application, builds on whatever is accepted theory at any given stage of the cycle. Investment theories tend to lurch forward in leaps, usually after the disappointment of a prolonged bear market. New theories emerge, correcting the ills exposed by a calamitous decline and engineering applies the new wisdoms.

It should not surprise us that the applications of today's financial engineer seem internally consistent, sound and almost unassailable. That would always be found after decades of reconfirmation of market and portfolio theory. But we should not be lulled into complacency by a catechism built on data of only a few decades. Nor should we imagine that portfolio theory, as we know it today, is the end of investment knowledge. There will be new theory and new engineering to apply it. But it may have a different label than the contemporary financial engineering. Finally, one of the consequences of the development of computer and financial technologies (as well as the long bull market) is the incredible growth in electronic trading. This has both good and bad implications for ordinary investors. On the positive side, the tools developed by cutting-edge financial institutions over two decades ago are now available to the individual household. Yet as with most technologies, the tools are more advanced than the general population's understanding of how to use them properly. Although trading costs have come down dramatically for the individual investor, the possibility of doing serious damage to one's nest egg is even greater.