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When doing any sort of theoretical work in finance or economics, academics often make the assumption that markets are rational and efficient. This assumption is

by exelius 12y ago

When doing any sort of theoretical work in finance or economics, academics often make the assumption that markets are rational and efficient. This assumption is almost universally false. They know that markets are neither: markets may or may not be rational (we can never realistically gather enough data to know thanks to information asymmetry) and they certainly aren't 100% efficient over most timelines. Just because the assumption is wrong doesn't mean it's not useful: without it, you can't even build a reasonable model of financial markets. But because the assumption is core to financial modeling, this means that all financial models are wrong. In fact, that's exactly how my financial modeling professor opened up the first class: by explicitly stating that all models are wrong in some way. You have to understand the ways that the model can be wrong in order to make any substantive claims about it. The Black-Shoals options pricing model assumes market liquidity; it's not very useful if you're talking about an asset that isn't very liquid. Misunderstanding when models should and should not be applied is one of the core reasons we got into an asset bubble in the mid-2000s. Banks were pricing financial products using models whose assumptions did not hold over the long-term. They didn't understand how their models were wrong until it was too late, and it ended up losing them (but ultimately the American taxpayers) a lot of money. But because the assumption that markets are always rational and efficient is wrong, it doesn't follow that markets are never rational or efficient. Markets can be rational and efficient, but it depends on the relative timeframe and the structure of the market involved.

aetherson 12y ago
Newtonian mechanics is wrong. It's wrong, wrong, wrong, wrong, wrong. We know it's wrong, and we've known for about a century now. But it turns out that it's still a good idea to teach Newtonian mechanics -- it's a useful model, as long as you know its limitations.
- mikeash 12y ago
  It's wrong in some scenarios, but it's still correct (to within many, many decimal places) in many others. Theories and models aren't just right or wrong. Some are more wrong than others. Isaac Asimov summed it up better than I could: http://chem.tufts.edu/answersinscience/relativityofwrong.htm http://chem.tufts.edu/answersinscience/relativityofwrong.htm Newtonian mechanics isn't so much wrong as it is incomplete. Is anything in economics like that? It doesn't seem so.
  - aetherson 12y ago
    Let's be clear: It's wrong in all scenarios. It turns that it produces results that are close enough to reality to be good enough in lots of scenarios. (And, similarly to how you can ignore relativity in lots of scenarios, you can also ignore lots of other complexifying bits of physics some of the time -- plenty of mechanical equations will give you "good enough" results without taking into account air resistance, for example). Yes, much of economics is like that. Economics is studying an inherently more complicated problem than simple billiard-ball mechanics, but the idea that economics has nothing useful to say about the real world is an agenda sold by people who don't like the implications of orthodox economics.
    - exelius 12y ago
      Economics is even more complex than physics in this regard, because in physics there is often a "right" answer. In economics, there may or may not be a right answer depending on the subject, but it's impossible to know if you've achieved it in most cases anyway. And what investors try to do would be akin to asking a physicist to examine two cars before a Nascar race and tell you who was going to win the race.
    - spott 12y ago
      >Let's be clear: It's wrong in all scenarios. You are attempting to measure the objective truth inherent in some model. Be careful with this (or at least be explicit about it). Newtonian mechanics is pretty accurate to an astonishing degree[0]. To call it "wrong in all scenarios" is saying that because it is wrong in one scale, it is wrong in another. At which point every physics theory we have is "wrong in all scenarios". The standard model can't predict or talk about planck level physics, and thus, it is "wrong in all scenarios". GR can't talk about quantum gravity and thus is "wrong in all scenarios". Hell, the Schrödinger equation is "wrong in all scenarios". If you believe in a fundamental truth inherent in some equation or model of some system, that is fine. But I think that is far from an accepted point of view. [0]http://www.npl.washington.edu/eotwash/sites/www.npl.washington.edu.eotwash/files/webfiles/publications/pdfs/TorsionBalanceTestsOfEP2012.pdf http://www.npl.washington.edu/eotwash/sites/www.npl.washingt...
jerf 12y ago
The real problem with "market efficiency" arguments is that nobody is arguing about market efficiency. What people really want to argue is that they are smarter than the markets, or that they are capable of guessing what the markets are going to do better than the markets. This means that they or their intellectual fellow-travelers should therefore be given power over the market which they can use to make it do the "right" things by virtue of their insight. Unfortunately, "the market is irrational" doesn't imply "you can name the ways in which it is irrational" nor does it imply even that there exists any single entity that is capable of correctly naming the way in which it is irrational. It is perfectly capable of having, and indeed almost certainly has, a chaotic, highly-information-packed, very fast-moving irrationality that is beyond any human or human institution's ability to understand, quantify, express, predict, control, harness, or "fix". I do not mean that figuratively or metaphorically... there's no reason to believe the market's irrationality is even remotely comprehensible. So the argument shouldn't be phrased in terms of whether the market is efficient or not... everybody knows it isn't. So let's cut to the chase... why do you (for generalized values of "you") think you know better, and if you do know better, why aren't you using it to make a killing, or, alternatively, how about you write down some interesting predictions about what's going to happen in three or four years and demonstrate the rightness of your theories? Say something interesting and verifiable, and let's see how you do. In the meantime, merely making the tedious observation that the market isn't "really" rational gets you no points, and I perceive no obligation on my part to change any of my political beliefs merely because "the market isn't rational". On the other hand, make correct predictions years in advance, especially if you can do so reliably, and I will sit up and take notice, I promise you. But, be warned, I'm very familiar with the process of bending a prediction to fit the data and that's not going to cut it... I demand that you be right, full stop. If you can't do that... welcome to the group of people who know the economy is irrational but can do nothing meaningful about it, population: entire rest of humanity.
- exelius 12y ago
  > Unfortunately, "the market is irrational" doesn't imply "you can name the ways in which it is irrational" nor does it imply even that there exists any single entity that is capable of correctly naming the way in which it is irrational. Absolutely. The number of players involved and the level of information asymmetry mean that it's not even knowable how the market is or isn't irrational. You're basically arguing that "alpha" is an illusion borne out of the quirks of distributed probability. I (along with many leading minds in finance) also believe this to be true. What many hedge funds call "alpha" is often just dumb luck. In the few cases that it isn't, policy changes at central banks are often involved (this is why it's taken the fed several years to choreograph the wind-down of QE). But the irony here is that the fact that everyone believes they can beat the market is what makes the market as efficient and liquid as it is. If everyone traded with the same strategy, you'd see massive swings in volatility and information asymmetry would be an even bigger issue than it is. Because there are so many different trading strategies built to hunt out arbitrage in certain pockets, the market as a whole is incredibly efficient - or at least more efficient than it would otherwise be. Whether or not they are capable of guessing the direction of the markets is irrelevant: if you take a portfolio strategy and make equal bets on enough different assets, you'll end up with something that is probably close to the market rate of return anyway. Note that this only applies to the "professional investor" class (as defined by the SEC); everyone else is simply better off in mutual funds. Professional investors have access to classes of securities with a higher average rate of return than normal citizens do, so they likely can beat the market as long as they're also able to absorb big losses in the years they don't beat the market.
twblalock 12y ago
All models are wrong. Some models are useful. Problems occur when people expect the model to correspond 100% to reality, which it was never intended to do. It is confusing the map for the territory. Unfortunately most journalists have this tendency.
lordnacho 12y ago
>Misunderstanding when models should and should not be applied is one of the core reasons we got into an asset bubble in the mid-2000s. Banks were pricing financial products using models whose assumptions did not hold over the long-term. They didn't understand how their models were wrong until it was too late, and it ended up losing them (but ultimately the American taxpayers) a lot of money. I don't think this is true. Plenty of smart people who worked with various models knew their data wasn't solid and reflected just a few years of a benign market, and plenty of people understood the rather obvious idea of a Black Swan. The reason they kept at it was systemic: they were paid to sit and cheer the market up, continue to sell product, and generally not question the business model. The people who made a lot of money off the crash tended to be people who were able to sit out the upswing in some way, without being punished too hard. Hedge fund managers with either new funds or long track records, like Paulson and Andrew Lahde. The crash was always coming. I remember going to a luncheon at GS where that was the major point. This was in 2006, and they predicted it would start in 2007 and culminate in 2008.
- rhino369 12y ago
  Some knew, but most didn't appreciate the risk correctly. Of course they knew about the idea of black swan events, but 2008 was not a black swan event. It was caused by a rather mild dip in real estate prices and a rather mild amount of mortgage defaults. The problem was that models assumed some risks were uncorrelated and in 2008 they became highly correlated. A lot of major wall street institutions got destroyed by it.
  - lordnacho 12y ago
    >The problem was that models assumed some risks were uncorrelated and in 2008 they became highly correlated. 2008 was not the first time correlation shot to 1. Sure, it's hard to model, I'll admit that. But to think that nobody had considered this is wrong. I saw a bunch of people who knew the models were wrong, but nobody had the balls to say so while the spreadsheets still worked.
- exelius 12y ago
  It was. Their models made the assumption that debt ratings were accurate, and they were substituting leveraged mortgage backed securities with AA ratings for risk-free debt. They also underestimated the effects that a liquidity crunch would have - any asset model backed by volatile assets assumes liquidity, but doesn't tell you what will happen in a period of non-liquidity. Most models assume financial markets are a continuous function, when in reality markets are mostly continuous with periodic step functions. When you hit a period with a step function, the market is either being irrational or correcting prior irrationality. You can't predict these step functions with any accuracy; though many of the big investment banks knew it was coming a year or two in advance. But even if you can predict them, there is no good way to model them. Goldman Sachs, for all its faults, is run by exceptionally competent people. They came out of the downturn stronger than they went in. They understand the models well because they built most of them. But there were plenty of large market players at Lehman, Merrill, Nationwide, etc. who were ignorant of the problems until it was too late. These are the people who just did what the model told them to because it was making them money, and they didn't understand the risk exposure they really had.
paganel 12y ago
> Misunderstanding when models should and should not be applied is one of the core reasons we got into an asset bubble in the mid-2000s. Banks were pricing financial products using models whose assumptions did not hold over the long-term. IMHO there's nothing wrong with economic bubbles, there's no economic law that I know of which says that economic growth should only happen linearly. What was wrong with the financial bubble of 2008 was the way it was handled, starting with the Bear Stearns bailout in early 2008 (of which not many people speak anymore, is like everything started with Lehman Brothers in September). Yes, banks had made some very wrong assumptions and they should have paid dearly for them, like in any free market. That didn't happen.
spott 12y ago
Just out of curiosity, how do you model crashes with an assumption of "efficient and rational" markets?
- exelius 12y ago
  You don't; and most models don't even try because the causes behind market crashes are often complex, interdependent relationships that often aren't fully understood until after the crash has happened. But you can use other tools to perform a catastrophic risk analysis that basically asks questions like "Let's say our assumptions change; what does this model look like in a world where every mortgage-backed security drops to junk status?". Problem is, the companies selling said securities have no interest in identifying the downside. Nor are they legally obligated to since they are selling these products to "professional investors" who ostensibly should know better.

by exelius 12y ago

aetherson 12y ago

Newtonian mechanics is wrong. It's wrong, wrong, wrong, wrong, wrong. We know it's wrong, and we've known for about a century now. But it turns out that it's still a good idea to teach Newtonian mechanics -- it's a useful model, as long as you know its limitations.

mikeash 12y ago
It's wrong in some scenarios, but it's still correct (to within many, many decimal places) in many others. Theories and models aren't just right or wrong. Some are more wrong than others. Isaac Asimov summed it up better than I could: http://chem.tufts.edu/answersinscience/relativityofwrong.htm http://chem.tufts.edu/answersinscience/relativityofwrong.htm Newtonian mechanics isn't so much wrong as it is incomplete. Is anything in economics like that? It doesn't seem so.
- aetherson 12y ago
  Let's be clear: It's wrong in all scenarios. It turns that it produces results that are close enough to reality to be good enough in lots of scenarios. (And, similarly to how you can ignore relativity in lots of scenarios, you can also ignore lots of other complexifying bits of physics some of the time -- plenty of mechanical equations will give you "good enough" results without taking into account air resistance, for example). Yes, much of economics is like that. Economics is studying an inherently more complicated problem than simple billiard-ball mechanics, but the idea that economics has nothing useful to say about the real world is an agenda sold by people who don't like the implications of orthodox economics.
  - exelius 12y ago
    Economics is even more complex than physics in this regard, because in physics there is often a "right" answer. In economics, there may or may not be a right answer depending on the subject, but it's impossible to know if you've achieved it in most cases anyway. And what investors try to do would be akin to asking a physicist to examine two cars before a Nascar race and tell you who was going to win the race.
  - spott 12y ago
    >Let's be clear: It's wrong in all scenarios. You are attempting to measure the objective truth inherent in some model. Be careful with this (or at least be explicit about it). Newtonian mechanics is pretty accurate to an astonishing degree[0]. To call it "wrong in all scenarios" is saying that because it is wrong in one scale, it is wrong in another. At which point every physics theory we have is "wrong in all scenarios". The standard model can't predict or talk about planck level physics, and thus, it is "wrong in all scenarios". GR can't talk about quantum gravity and thus is "wrong in all scenarios". Hell, the Schrödinger equation is "wrong in all scenarios". If you believe in a fundamental truth inherent in some equation or model of some system, that is fine. But I think that is far from an accepted point of view. [0]http://www.npl.washington.edu/eotwash/sites/www.npl.washington.edu.eotwash/files/webfiles/publications/pdfs/TorsionBalanceTestsOfEP2012.pdf http://www.npl.washington.edu/eotwash/sites/www.npl.washingt...

jerf 12y ago

The real problem with "market efficiency" arguments is that nobody is arguing about market efficiency. What people really want to argue is that they are smarter than the markets, or that they are capable of guessing what the markets are going to do better than the markets. This means that they or their intellectual fellow-travelers should therefore be given power over the market which they can use to make it do the "right" things by virtue of their insight. Unfortunately, "the market is irrational" doesn't imply "you can name the ways in which it is irrational" nor does it imply even that there exists any single entity that is capable of correctly naming the way in which it is irrational. It is perfectly capable of having, and indeed almost certainly has, a chaotic, highly-information-packed, very fast-moving irrationality that is beyond any human or human institution's ability to understand, quantify, express, predict, control, harness, or "fix". I do not mean that figuratively or metaphorically... there's no reason to believe the market's irrationality is even remotely comprehensible. So the argument shouldn't be phrased in terms of whether the market is efficient or not... everybody knows it isn't. So let's cut to the chase... why do you (for generalized values of "you") think you know better, and if you do know better, why aren't you using it to make a killing, or, alternatively, how about you write down some interesting predictions about what's going to happen in three or four years and demonstrate the rightness of your theories? Say something interesting and verifiable, and let's see how you do. In the meantime, merely making the tedious observation that the market isn't "really" rational gets you no points, and I perceive no obligation on my part to change any of my political beliefs merely because "the market isn't rational". On the other hand, make correct predictions years in advance, especially if you can do so reliably, and I will sit up and take notice, I promise you. But, be warned, I'm very familiar with the process of bending a prediction to fit the data and that's not going to cut it... I demand that you be right, full stop. If you can't do that... welcome to the group of people who know the economy is irrational but can do nothing meaningful about it, population: entire rest of humanity.

exelius 12y ago
> Unfortunately, "the market is irrational" doesn't imply "you can name the ways in which it is irrational" nor does it imply even that there exists any single entity that is capable of correctly naming the way in which it is irrational. Absolutely. The number of players involved and the level of information asymmetry mean that it's not even knowable how the market is or isn't irrational. You're basically arguing that "alpha" is an illusion borne out of the quirks of distributed probability. I (along with many leading minds in finance) also believe this to be true. What many hedge funds call "alpha" is often just dumb luck. In the few cases that it isn't, policy changes at central banks are often involved (this is why it's taken the fed several years to choreograph the wind-down of QE). But the irony here is that the fact that everyone believes they can beat the market is what makes the market as efficient and liquid as it is. If everyone traded with the same strategy, you'd see massive swings in volatility and information asymmetry would be an even bigger issue than it is. Because there are so many different trading strategies built to hunt out arbitrage in certain pockets, the market as a whole is incredibly efficient - or at least more efficient than it would otherwise be. Whether or not they are capable of guessing the direction of the markets is irrelevant: if you take a portfolio strategy and make equal bets on enough different assets, you'll end up with something that is probably close to the market rate of return anyway. Note that this only applies to the "professional investor" class (as defined by the SEC); everyone else is simply better off in mutual funds. Professional investors have access to classes of securities with a higher average rate of return than normal citizens do, so they likely can beat the market as long as they're also able to absorb big losses in the years they don't beat the market.

twblalock 12y ago

All models are wrong. Some models are useful. Problems occur when people expect the model to correspond 100% to reality, which it was never intended to do. It is confusing the map for the territory. Unfortunately most journalists have this tendency.

lordnacho 12y ago

>Misunderstanding when models should and should not be applied is one of the core reasons we got into an asset bubble in the mid-2000s. Banks were pricing financial products using models whose assumptions did not hold over the long-term. They didn't understand how their models were wrong until it was too late, and it ended up losing them (but ultimately the American taxpayers) a lot of money. I don't think this is true. Plenty of smart people who worked with various models knew their data wasn't solid and reflected just a few years of a benign market, and plenty of people understood the rather obvious idea of a Black Swan. The reason they kept at it was systemic: they were paid to sit and cheer the market up, continue to sell product, and generally not question the business model. The people who made a lot of money off the crash tended to be people who were able to sit out the upswing in some way, without being punished too hard. Hedge fund managers with either new funds or long track records, like Paulson and Andrew Lahde. The crash was always coming. I remember going to a luncheon at GS where that was the major point. This was in 2006, and they predicted it would start in 2007 and culminate in 2008.

rhino369 12y ago
Some knew, but most didn't appreciate the risk correctly. Of course they knew about the idea of black swan events, but 2008 was not a black swan event. It was caused by a rather mild dip in real estate prices and a rather mild amount of mortgage defaults. The problem was that models assumed some risks were uncorrelated and in 2008 they became highly correlated. A lot of major wall street institutions got destroyed by it.
- lordnacho 12y ago
  >The problem was that models assumed some risks were uncorrelated and in 2008 they became highly correlated. 2008 was not the first time correlation shot to 1. Sure, it's hard to model, I'll admit that. But to think that nobody had considered this is wrong. I saw a bunch of people who knew the models were wrong, but nobody had the balls to say so while the spreadsheets still worked.
exelius 12y ago
It was. Their models made the assumption that debt ratings were accurate, and they were substituting leveraged mortgage backed securities with AA ratings for risk-free debt. They also underestimated the effects that a liquidity crunch would have - any asset model backed by volatile assets assumes liquidity, but doesn't tell you what will happen in a period of non-liquidity. Most models assume financial markets are a continuous function, when in reality markets are mostly continuous with periodic step functions. When you hit a period with a step function, the market is either being irrational or correcting prior irrationality. You can't predict these step functions with any accuracy; though many of the big investment banks knew it was coming a year or two in advance. But even if you can predict them, there is no good way to model them. Goldman Sachs, for all its faults, is run by exceptionally competent people. They came out of the downturn stronger than they went in. They understand the models well because they built most of them. But there were plenty of large market players at Lehman, Merrill, Nationwide, etc. who were ignorant of the problems until it was too late. These are the people who just did what the model told them to because it was making them money, and they didn't understand the risk exposure they really had.

paganel 12y ago

> Misunderstanding when models should and should not be applied is one of the core reasons we got into an asset bubble in the mid-2000s. Banks were pricing financial products using models whose assumptions did not hold over the long-term. IMHO there's nothing wrong with economic bubbles, there's no economic law that I know of which says that economic growth should only happen linearly. What was wrong with the financial bubble of 2008 was the way it was handled, starting with the Bear Stearns bailout in early 2008 (of which not many people speak anymore, is like everything started with Lehman Brothers in September). Yes, banks had made some very wrong assumptions and they should have paid dearly for them, like in any free market. That didn't happen.

spott 12y ago

Just out of curiosity, how do you model crashes with an assumption of "efficient and rational" markets?

exelius 12y ago
You don't; and most models don't even try because the causes behind market crashes are often complex, interdependent relationships that often aren't fully understood until after the crash has happened. But you can use other tools to perform a catastrophic risk analysis that basically asks questions like "Let's say our assumptions change; what does this model look like in a world where every mortgage-backed security drops to junk status?". Problem is, the companies selling said securities have no interest in identifying the downside. Nor are they legally obligated to since they are selling these products to "professional investors" who ostensibly should know better.