Skip to content

Physics, Biology, or Peltzman?

January 3, 2012

Quantivity is fortunate to be acquainted with numerous folks who have earned consistent returns over multiple decades without significant drawdown. Although they have varying trading strategies, there is a common theme which unifies them: top-down systematic focus on the sociology of market participants.

This focus is not behavioral finance, in search of anomalies driven by cognitive biases divergent from equilibrium (although majority do that too). Rather asking inferential sociological questions, such as: was the market “efficient”, in the Fama sense, during the post-war decades prior to 2000 because people expected it to be (blissfully ignoring a few hiccups); in contrast to how it is commonly understood and formalized, with reverse causality: market is assumed to be efficient, thus people understand it as such.

Similarly, have the past 15 years been “inefficient”, in the bubble and anomaly sense, because cultural faith among investors in such “efficiency” was lost; or, did they lose faith because the market became inefficient? Big difference.

In other words: is finance governed by physics, biology, or Peltzman?

The traditional answer of market hypothesis, provided by financial economics via microeconomic principles of equilibrium and efficiency: causality flows from market to investor. This explanation comes in two variants, known by their colloquial analogical fields:

  • Physics: market is governed by immutable mathematical principles and can be formalized into coherent predictive models, either in favor or contradiction of excess returns; exemplified by classic weak/strong EMH theory
  • Biology: market is governed by evolutionary principles ala Darwin, as exemplified by Lo’s 2004 AMH article: “Very existence of active liquid financial markets implies that profit opportunities must be present. As they are exploited, they disappear. But new opportunities are also constantly being created as certain species die out, as others are born, and as institutions and business conditions change.” (p. 24)

Yet, both these explanations suffer from implicitly begging the question: conjure “a market” with desired attributes and then derive conclusions. The physics perspective assumes immutability, conceivability, and mathematical expressiveness for its hypothesized market. While the biology perspective endows the hypothesized market with even more sophisticated Darwinian traits, presumably driven by underlying physical principles so inscrutable as to defy mathematical formalization.

An alternative explanation is to apply the self-fulfilling Peltzman effect to financial markets, and reverse causality: markets behave as they do because of investor sociology, rather than arising emergent from implicit cooperation of equilibrium-seeking rational microeconomic agents.

In other words: when investors believe the market is rational (irrespective of whether that belief is well-founded), then they embody Dunning-Kruger by ex ante faithfully dumping money into their 401K each month; in doing so collectively, the investment management industry undertakes its rent seeking activity resulting in the market possessing ex post “efficient” characteristics. Conversely, when investors believe the market is irrational, they either: go to cash, pursue uninformed non-collective trading, or both. Both of which result in anomalous market behavior, uncontrollable by the industry, either due to decreased liquidity or absence of predictable momentum.

If the market is indeed Peltzmanian, then the real question is how to best quantify and model primary and spillover effects resulting from investor sociology as they unfold ephemerally.

About these ads

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Follow

Get every new post delivered to your Inbox.

Join 231 other followers

%d bloggers like this: