The simple answer is ‘both’. Finance whether for business or study has strong roots in the science of mathematics and statistics and a lot of modern financial theories resemble scientific language. Yet the financial industry is affected by the decisions made from human emotions in many ways, giving it an element of being an art as well as a science. For many people, finance = math where it is all about numbers and science and proven identities and historical performance. For others, finance is about psychology, emotion, and the endless possibilities on offer from which to make a choice or plan.
Finance as science
In the financial world there are incontrovertible mathematical realities. If your outgoings consistently surpass your income, you will end up in debt is a simple example. Use of the laws of statistics and mathematics found in science are found in modern financial theories. The Black Scholes model, a model of price variation over time, for stocks as an example, would not exist without these scientific laws. Theoretical constructs such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH) attempt to logically explain the behaviour of the stock market in an emotionless, completely rational manner, entirely ignoring elements such as market sentiment and investor emotions.
There’s an argument to be made that financial turmoil emanates from an excessive and grossly misdirected use of mathematics for the purpose of generating profits for financial institutions. While scientific and academic advancements have helped improve the operations of the financial markets, the stock market crashes such as the Oct 1987 crash (Black Monday), which saw the Dow Jones Industrial Average fall more than 22 percent and the great 1929 (Black Thursday) crash that spurred the Great Depression, cannot be fully explained by scientific theories such as the Black Scholes model.
In personal finance it has statistically been shown that the best way to save for retirement is through a balanced portfolio of stocks and bonds held for at least 20 years and periodically rebalanced. Yet there is conflict of studies and opinions about how often you should contribute, the percentage of stocks, bonds and cash to be held and when the portfolio should be rebalanced.
Calculations like interest rates, amortization schedules, regular dividend distributions and average market index returns are scientific since there’s no debate about the numbers used. Yet science dos not allow the market to be consistently timed for maximum effect, even if a particular approach has worked reasonably well over time.
Finance as art
Finance is also an art as it has become more analytical. New financial theories give alternatives to raising and managing money, but these financial theories are not scientifically proven. As an example, analyse of historical trends will not prove that interest rates will change in a definite pattern. Financial guidelines and theories are useful in financial decision making, but they need additional input.
All investors know that markets are not entirely scientific. Studies have shown that investor behaviour can 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.
The ability of some investors, like Warren Buffett who has created the bulk of his wealth from long-term equity investments, to consistently outperform the broader market for long periods of time, discredits the EMH, leading some to believe that to be a successful equity investor, one needs to understand the science behind the numbers and the art behind the stock picking by such investors.
We can calculate statistics, but the many variables in finance, including the geopolitical landscape, the weather, income and stock market performance, preclude certainty. With variables in finance, making a plan is an art. Statistics can help with probabilities, but with no certainties, even the most rigorous analysis cannot protect from arbitrary market moves.
Perhaps finance is best described as a ‘scientific art’ where finance is the science of knowing how to predict financial consequences and the art of knowing when to act.