Wednesday, May 21, 2008

Note: People aren't simplistic.


The New Paradigm for Financial Markets includes Soros’ verdict on the credit crisis. He thinks, as has been widely reported, that it is the most severe since the 1930s, and that it marks the end of a 25-year “era of credit expansion based on the dollar as the international reserve currency”...

His insights are clear and concisely expressed. They are worth reading for anyone interested in the topic. But what is most interesting, and obviously engages Soros at an emotional level, is the idiosyncratic philosophy he has developed to explain the metaphysics of how markets work. Even before the emergence of the efficient markets hypothesis, which has dominated academic thinking on markets for at least three decades, Soros had devised his own theory to prove markets were not efficient. He acted on this philosophy as an investor with spectacularly successful results.

That philosophy derived from his undergraduate studies at the London School of Economics under Karl Popper. The “relationship between thinking and reality”, Soros calls “reflexivity.” It fills the book’s centre in chapters which he admits many will find “heavy going”. In markets, Soros says, participants’ thinking plays a dual function: they try to understand the situation (the “cognitive function”), and to change it (the “manipulative function”). The two functions can interfere with each other; when they do so the market displays “reflexivity”.

So an investor’s misperception of reality can help to change that reality, begetting further misperceptions. When market actors’ decisions affect outcomes, patterns emerge. If a lot of people are bullish about internet stocks their price goes up. Soros used the theory to predict, and profit from, a series of “initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles”. Each bubble “consists of a trend and a misconception that interact in a reflexive manner”.

A key implication of this is that markets do not tend towards “equilibrium”, as predicted by modern portfolio theory. And they will not move in the “random walk” promulgated by efficient markets theory, which holds that prices always incorporate all known information and so move randomly in response to new information.

So "The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means" has to be added to my reading list, along with Ariely's book "Predictably Irrational."

Oh, wait, I gotta put in one more quote...

Many will dislike Soros’ politics. Others will find the book self-indulgent. He calls himself a “failed philosopher” and badly wants his theory to reach a broader public. It is hard to imagine it would have been published were he not so famous and successful.

I have become fond in recent years - especially with the exigencies of my current project - of quoting Deng Tsao Ping's "It does not matter if a cat is black or white, as long as it catches mice." I could rephrase the last sentence in this as "It is hard to imagine it would have been published were he not so famous and successful his results indicative of the usefulness of his approach."

Within economics you have the classic issue of measure/probability theory: the underlying space - think of the set of all humans engaging in the economy or all humans' economic actions -just doesn't behave as the theory demands it to in order for all the other nice juicy stuff to follow.

Soros is right. Conservative economics - supply side Reagan/Thatcher/Norquist BS is as dead as a McDonald's Big Mac.

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