A Fatal Flaw in Reasoning

Financial economics has a basic fundamental fatal flaw. That flaw is that:

Financial Economics assumes that no one pays any attention to Financial Economics.

So if we stopped reading and listening and thinking about the insights of financial economics, they are at least somewhat more likely to actually be true.  At least for longer than they are now. 

But in the recent past, say the last 40 years, more and more people are trying to use the insights of financial economics to guide their actions in the financial markets. 

The problem is that once they do that, they are no longer acting like the rational actors that financial economics assumes that they are.  Those rational actors would have used their own insights about the way that markets work to make their decisions.  That is the way that decisions were made during the past time periods that financial economists studied to prove that their theories were reasonable.  Perhaps many people in those historical periods were being informed by earlier, now discredited, financial theories. 

But now, most people who now move money in the financial markets are informed by the exact same financial theories.  That is different from the past because now we have better communications and better education systems so that these best ideas are much more ubiquitous.  So there are large groups of folks who are all using the exact methods of analysis and decision making.  Those methods often are based upon a freeze tag assumption. 

Freeze tag is the children’s game where one person is it and as he or she tags the other palyers, they all freeze. 

The Freeze tag assumption that is built into the models that everyone uses is the assumption that we are all marginal to the market.  We are assuming that while we are doing our analysis and making our choise that the entire market is frozen AND that no one else is doing the analysis or making the decisions that we are making. 

“The technical explanation is that the market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them.”  Avinash Persaud

Financial economics is like magic that gets less and less powerful as more and more people learn it.  Once everyone can pull a coin from behind an ear, no one is very impressed by that trick. 

So the very success and power of financial economics ability to explain and predict financial markets resulted in more and more people adopting it which led to more and more herding of financial behaviors. 

That has led to a secondary issue.  Smart traders know this.  So just as financial economics provided the point of view and formulas and tools to look at how markets should act that applied to the world without financial economics, the smartest traders are looking at the world with financial economics to make their choices of trades to make their profits.  That takes the economic markets not one but two or more steps away from the pre financial economics markets. 

Game theorists have a game that they like where a group of folks are asked to guess the value of 2/3 of the average of their guesses.  If the range of possible guesses is 1 to 100, then all guesses above 66 are impossible, so the “right” answer is 44. But if only numbers below 66 are rational guesses, then you can rationally eliminate guesses above 2/3 of that value and so on until the only logical guess is 0. 

It is the problem that Keynes talked about with beauty contests (and stock markets):

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment Interest and Money, 1936).

Every financial economics theory has a tail like that.  Think about risk free rates.  Once you tell someone that a particluar interest rate is risk free, then those who can borrow at that rate will borrow more and more and more until the borrower is no longer  riskless.  An observation that a praticular rate was a good proxy for a risk free rate can only be correct in retrospect. In any forward sense, it is highly likely to be untrue. 

Businesses are hedging based upon measures of sensitivity of certain instruments to underlying financial information, “the greeks”.  But in October 1987, we found that those sensitivities were, in fact, totally variable based upon the number of people who were relying upon those relationships. 

This is all true because of the flaw in financial economics.  It would never have happened if financial economics papers were not published but were instead only read aloud at economics conferences. 

So what can risk managers learn from this story?  (This blog is for discussing matters of interest to risk managers, so that question is applied to each and every post.)

Risk managers can learn two things:  First, we need to have models that are not  based upon freeze tag type assumptions where “no one but us” knows of the theory.  And second, we need to be careful to try to not ourselves fall into this sort of cycle by getting into a process of trying to guess what everyone else’s risk models will be telling them.

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