We’re all looking for people to blame for the current mess we are in and apparently there are 38 causes of the current financial crisis. I’m not sure where to get hold of the original report so I’m not sure of what’s on the list but it made me think again about what I learned during my brief time working in the world of high finance a few years ago. I was there for a couple of years, so I'm clearly not hugely knowledgeable but the assumptions made when concocting the financial models used by many investors in the city always seemed a little fishy to me. Here are some of the main assumptions made and the problems I think are associated with them. Almost every financial theory will use one or more of these assumptions.
The market is efficient – All information about an asset is known and priced into the cost of that asset. Peston says this is one of the 38 causes. There are several issues with this theory, my favourite being this paradox – if the market is efficient then there is very little point in trying to play the market, since the market will always be priced accurately so there will be no opportunity to beat it by buying low, selling high. But if there are no players in the market, then it won’t be efficient. Which suggests it can never be perfectly efficient.
Another problem with the efficient market theory can be seen with something like the dot com bubble, where prices bore no relation to their underlying value, how is that sensible? The fact is share prices often bear no relation to the true worth of the company, because people think their value will continue to grow so they will be able to sell them on to a greater fool.
Investors are rational - Given two different assets with the same risk, investors will choose the one with the highest return. Clearly this isn't the case, otherwise bubbles would never happen. Another problem is that even a rational investor may not know the true risk/reward relationship. Shares may fall in value, making their dividend yield look very attractive, but there may be a good reason for this, like the economy is hitting trouble. Finally, some investors are just taking a punt, with no rational thought behind their trading.
Finally, if we decide that not all investors are rational, then we have another reason why the market will not be efficient.
There are no transaction charges – This may be nearly true for large institutional investors but for the man on the street this is very much not true, meaning any kind of investment strategy that involves a lot of trading will incur huge transaction costs, which will eat away at any profits made.
The market is liquid - This assumption basically says if you want to buy or sell, then you can. Whilst this holds true for most shares most of the time, it falls over at the most vital point, when markets are crashing, because everybody is trying to sell and there is nobody willing to buy. It is also not true for quite a few asset classes, as anyone who's tried to sell a house will know.
Normal distribution – A lot of financial theories use the normal distribution for the distribution of volatility/risk. Unfortunately this doesn’t seem to be the case. The black swans seem to occur a lot more frequently than a normal distribution would suggest. For the banks out there, this doesn’t seem to be such a problem, since they take the profits during the good times and get bailed out when those once in a lifetime occurrences strike a little too often.
And it’s the combination of all these flawed assumptions that caused at least some of the problems. They were used to build mathematical models that seemingly abolished risk or certainly incorrectly measured it.
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