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Reality Intrudes

September 13, 2009

One of the great fantasies of financial economics is the Efficient Market Hypothesis, originated posited by Bachelier and popularized by Fama. Although this may be true in some very limited asymptotic statistical sense (which arguably is what Bachelier, but not Fama, intended), it certainly is not true from the perspective of any individual trader—or even, the bulge bracket, it now appears. What is particularly interesting for traders is understanding why this hypothesis is not correct, as the underlying factors evolve over time (with commensurate opportunity for profit, as proved nicely by Swenson and Birnbaum with ABX).

Along this line, The New York Times has run two excellent pieces (for the popular press) acknowledging the various ways reality intrudes into the beautiful formal worlds of both quantitative finance and macroeconomics.

Today, Wall Street’s Math Wizards Forgot a Few Variables covers the role of behavioral finance from several idiosyncratic angles, including liquidity risk and online social networking. The latter is a particularly interesting angle for exploration. Favorite quote from the article:

In the aftermath of the economic crisis, financial engineers, experts say, will probably shift more to risk management and econometric analysis and concentrate less on devising exotic new instruments.

From a different (yet complementary) angle, Krugman published an excellent survey article, How Did Economists Get It So Wrong?. The generations of economics students who found little practical use in classic macro theory undoubtedly quietly cheered a bit inside while reading this article. Ultimately, his argument boils down to the following, triangulating with the previous article:

Economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth.

For anyone who spent time in academic economics, this should ring crystal clear.

What distinguishes both articles is their recognition that the improper use of mathematics is the problem, rather than trying to blame mathematics itself or its use (as was done in previous crises). Maybe we all have learned something from the 2008 crisis, after all.

[Note: hardcore quant analysis (including regime dashboard) will return shortly; absence of recent posts due to intense focus on several new trading strategies and a wonderful life event.]

2 Comments leave one →
  1. QuantPlus permalink
    October 20, 2009 7:00 pm

    The EMH generalization is hardly a “fantasy”. For > 99% of the population and > 90% of “day traders”, the market is “de facto perfectly efficient”. For experienced quants, the market has a fairly broad spectrum of “efficiency”… ranging from “exploitable” to “prohibitively efficient”. Also, rampant, institutionalized market manipulation DISTORTS the market, creating “artificial inefficiencies”.

    • quantivity permalink
      October 22, 2009 12:08 am

      @QuantPlus; thanks for your comment. I would not disagree, but would note that efficiency (in the strict theoretic sense) and exploitability are not equivalent.

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