4 ms·

6. Market goes rational (inevitable, forces pushing it irrational can't do so forever), valuation plumets [sic] It's a nitpick, but the only irrationality that

by mkn 15y ago

6. Market goes rational (inevitable, forces pushing it irrational can't do so forever), valuation plumets [sic] It's a nitpick, but the only irrationality that gets checked is unsustainable irrationality. It's a bit of a simplification to say that profits are actually "equilibrium irrationality," but not by much. If the market were actually composed of rational agents, all prices would be driven down to material cost + wages, and there'd be no need for advertising, either. Forces can, and in fact always do, push the market to irrationality. The only thing the market seems to do is moderate the degree of irrational excess. I'm not really going anywhere with this. I just have a fascination with people's manifold faith in markets and their powers. It's interesting that "free market theory" flatters consumers (as rational) and benefits businesses (via consumer irrationality). I think that this is why the notion survives so well in popular culture.

justin_vanw 15y ago
I wouldn't claim that the market generally is efficient, but I strongly suspect that it a lot like Brownian Motion. No observer could possibly predict which direction it will jump next, but the overall parameters are determined in some fundamental way. I call this Brownian because to someone observing the motion of a single atom, it appears random, but it is entirely determined by the motion and position of other atoms that end up colliding with it, and there are fundamental conditions, such as the overall temperature or density of the stuff surrounding the atom being observed, but while knowing those things lets you make predictions, those predictions only hold after averaging over a very large number of atoms or a very long amount of time, and by then, if you aren't in a carefully controlled laboratory environment, the global conditions will have changed enough that your predictions aren't sensible any longer. However, it's not efficient, since there is a lot you can do to make a better guess than assuming it is a completely random process. While this will make it more efficient, there are plenty of people making random guesses, which reduces the effect your better guesses have on the overall efficiency of the market. There are also plenty of fools, and they are investing on all sorts of techniques which ignore any of the global considerations, and of course this is how bubbles expand.
- dxbydt 15y ago
  " I strongly suspect that it a lot like Brownian Motion" 1.Mkt isn't like BM. BM permits -ve values & any market index say SPY must be non-negative. 2. We (quants) model market indices like SPY as a log-normal process like so : dS = rSdt + sigmaSdz where S = underlying ( or market index ) dS = change in S, dt = change in time r = risk free interest rate ( about 0.03 % currently ) dz = normally distributed rv with mean 0, std dev sigma There is an embedded Brownian component in dz, so also in S. But that doesn't make S itself Brownian. More here: http://en.wikipedia.org/wiki/Wiener_process http://en.wikipedia.org/wiki/Wiener_process "No observer could possibly predict which direction it will jump next" Nobody is trying to do that in the very next instant. OTOH, you can certainly predict where the market will go, say, in a year. Well known econ result: DP ratio regresses positively with return. ie. Dividend-price ratio predicts stock return with high statistical significance. Source: Cochrance, French/Fama, et al. http://dash.harvard.edu/bitstream/handle/1/3122601/campbellssrn_stockreturn.pdf?sequence=2 http://dash.harvard.edu/bitstream/handle/1/3122601/campbells... "there are plenty of people making random guesses...there are also plenty of fools, and they are investing on all sorts of techniques which ignore any of the global considerations, and of course this is how bubbles expand." Ha ha ha! Very amusing but very inaccurate. I think this is my general problem with geeks on the outside of finance. They happen to think markets are purely stochastic. X has randomness doesn't mean X is unpredictable. Otherwise why have APT, CAPM, covariance matrices, factor models, Heath Jarrow, Black Litterman...you've written off some 100+ years of economics in one breath ! To summarize, there are tons of observers, who predict where the overall market or some portfolio of equities ( or bonds or agencies or munis or treasuries or whatever else ) will go. To get data points for these predictions, you use a historical time window, compute coVar matrices, invert them, build a CAPM....etc. Anyways, its not rocket science. There are tons of CFAs & Finmath engg ( I'm one of them ) who do this sort of work day in and day out. Its our bread & butter. If I said something like "market is a lot like brownian motion & people are making random guesses", I'd be out of a job.
  - justin_vanw 15y ago
    "Otherwise why have APT, CAPM, covariance matrices, factor models..." So are you saying you consistently outperform the market? If not, what are you 'modeling'? In 'science', a model is considered useful in how well it predicts the observations of some experiment, especially experiments on effects which were not known when the model was created. What do your bragged about models predict? What are they good for besides talking about with other quants?
jerf 15y ago
The "efficient market hypothesis" is broadly misunderstood. What it really says is something more like "a free market will strongly tend not to have easy arbitrage opportunities", not that it's guaranteed to produce a result that conforms to any particular person's goals for ideal societies or anything, not even free market advocates. (Micro)-Economics is much more like physics; here is how it tends to work, how it tends to optimize, how it tends to in practice actively subvert attempts to predict what it will do (and thereby actively resisting any attempt to create a macro-economic theory, or at least one that lasts for any period of time). It's a very physics-like definition of "efficiency". The fact that the dam broke in the most energy-efficient manner and the resulting water deluge can be modeled with a high degree of accuracy by assuming it will follow the least-energy course in an efficient manner doesn't make the resulting flood "good" or "desirable"... just... efficient. On the other hand, start your economics model with anything else and it's like trying to rewrite physics starting with material ether or something. I have "faith in the markets" in much the same way I have faith in physics (which I will remind you contains a lot of similar "merely statistical" theories, what you learned in school is the aberration, not the rule, and also is really strong on the fundamentals and gets progressively weaker as the systems get larger, rather like economics), but that doesn't mean I blindly trust them. Physics will kill you without blinking. But if you want to prevent that, it's a lot better to come to understand the laws of physics than to try to create new rules for the universe by sheer force of denial. Trying to guide the physics while actively refusing to learn about it is doomed to failure, too. Same for microecon.

by mkn 15y ago

justin_vanw 15y ago

I wouldn't claim that the market generally is efficient, but I strongly suspect that it a lot like Brownian Motion. No observer could possibly predict which direction it will jump next, but the overall parameters are determined in some fundamental way. I call this Brownian because to someone observing the motion of a single atom, it appears random, but it is entirely determined by the motion and position of other atoms that end up colliding with it, and there are fundamental conditions, such as the overall temperature or density of the stuff surrounding the atom being observed, but while knowing those things lets you make predictions, those predictions only hold after averaging over a very large number of atoms or a very long amount of time, and by then, if you aren't in a carefully controlled laboratory environment, the global conditions will have changed enough that your predictions aren't sensible any longer. However, it's not efficient, since there is a lot you can do to make a better guess than assuming it is a completely random process. While this will make it more efficient, there are plenty of people making random guesses, which reduces the effect your better guesses have on the overall efficiency of the market. There are also plenty of fools, and they are investing on all sorts of techniques which ignore any of the global considerations, and of course this is how bubbles expand.

dxbydt 15y ago
" I strongly suspect that it a lot like Brownian Motion" 1.Mkt isn't like BM. BM permits -ve values & any market index say SPY must be non-negative. 2. We (quants) model market indices like SPY as a log-normal process like so : dS = rSdt + sigmaSdz where S = underlying ( or market index ) dS = change in S, dt = change in time r = risk free interest rate ( about 0.03 % currently ) dz = normally distributed rv with mean 0, std dev sigma There is an embedded Brownian component in dz, so also in S. But that doesn't make S itself Brownian. More here: http://en.wikipedia.org/wiki/Wiener_process http://en.wikipedia.org/wiki/Wiener_process "No observer could possibly predict which direction it will jump next" Nobody is trying to do that in the very next instant. OTOH, you can certainly predict where the market will go, say, in a year. Well known econ result: DP ratio regresses positively with return. ie. Dividend-price ratio predicts stock return with high statistical significance. Source: Cochrance, French/Fama, et al. http://dash.harvard.edu/bitstream/handle/1/3122601/campbellssrn_stockreturn.pdf?sequence=2 http://dash.harvard.edu/bitstream/handle/1/3122601/campbells... "there are plenty of people making random guesses...there are also plenty of fools, and they are investing on all sorts of techniques which ignore any of the global considerations, and of course this is how bubbles expand." Ha ha ha! Very amusing but very inaccurate. I think this is my general problem with geeks on the outside of finance. They happen to think markets are purely stochastic. X has randomness doesn't mean X is unpredictable. Otherwise why have APT, CAPM, covariance matrices, factor models, Heath Jarrow, Black Litterman...you've written off some 100+ years of economics in one breath ! To summarize, there are tons of observers, who predict where the overall market or some portfolio of equities ( or bonds or agencies or munis or treasuries or whatever else ) will go. To get data points for these predictions, you use a historical time window, compute coVar matrices, invert them, build a CAPM....etc. Anyways, its not rocket science. There are tons of CFAs & Finmath engg ( I'm one of them ) who do this sort of work day in and day out. Its our bread & butter. If I said something like "market is a lot like brownian motion & people are making random guesses", I'd be out of a job.
- justin_vanw 15y ago
  "Otherwise why have APT, CAPM, covariance matrices, factor models..." So are you saying you consistently outperform the market? If not, what are you 'modeling'? In 'science', a model is considered useful in how well it predicts the observations of some experiment, especially experiments on effects which were not known when the model was created. What do your bragged about models predict? What are they good for besides talking about with other quants?

jerf 15y ago

The "efficient market hypothesis" is broadly misunderstood. What it really says is something more like "a free market will strongly tend not to have easy arbitrage opportunities", not that it's guaranteed to produce a result that conforms to any particular person's goals for ideal societies or anything, not even free market advocates. (Micro)-Economics is much more like physics; here is how it tends to work, how it tends to optimize, how it tends to in practice actively subvert attempts to predict what it will do (and thereby actively resisting any attempt to create a macro-economic theory, or at least one that lasts for any period of time). It's a very physics-like definition of "efficiency". The fact that the dam broke in the most energy-efficient manner and the resulting water deluge can be modeled with a high degree of accuracy by assuming it will follow the least-energy course in an efficient manner doesn't make the resulting flood "good" or "desirable"... just... efficient. On the other hand, start your economics model with anything else and it's like trying to rewrite physics starting with material ether or something. I have "faith in the markets" in much the same way I have faith in physics (which I will remind you contains a lot of similar "merely statistical" theories, what you learned in school is the aberration, not the rule, and also is really strong on the fundamentals and gets progressively weaker as the systems get larger, rather like economics), but that doesn't mean I blindly trust them. Physics will kill you without blinking. But if you want to prevent that, it's a lot better to come to understand the laws of physics than to try to create new rules for the universe by sheer force of denial. Trying to guide the physics while actively refusing to learn about it is doomed to failure, too. Same for microecon.