I recently read the following book by George Soros:
In it the famous investor George Soros proposes his view of how financial markets work by putting forward the Theory of Reflexivity. Basically, he says financial market participants are not casual observers of the situation in markets. They are able to influence the present and future developments. This he calls the manipulative function. This is supposed to dismantle the Efficient-Market Hypothesis which says that market participants take the events as exogenous. Supply and Demand in economic models are exogenous. Soros shows that Supply tends to influence demand and vice versa, so they are endogenous.
Yes, Donald Trump, Federal Reserve Chairmen Ben Bernanke, Janet Yellen and Jerome Powell have the power to influence markets, so Soros is right that to a certain extent there is a manipulative function of market participants. But the problem is, with open market economies, freely flowing capital and markets in existence you never quite know what the effect of a certain policy will be. During Chairman Greenspan's tenure the Federal Reserve raised rates only to see the yield on ten year treasuries actually fall- which is known as the "Greenspan's Conundrum"- this happened in 2004-2006 period. Classical economics, on the other hand, is preoccupied with the fact that market participants only observe and analyze events - or what Soros calls the cognitive function. Classical economics seems to assume that no market participant is large enough to influence supply and demand - supply and demand are exogenous. That obviously is a long stretch, because the economy of the USA makes up about 20% of world's GDP and is obviously large enough to change reality or the world. The same is true for the actions of the Federal Reserve and the President of the USA.
George Soros wonders why his theory of reflexivity has not gained enough traction in both academic and practitioner circles. One explanation is that the theory is difficult to model, according to Soros. That, actually, is not true. Refelxivity theory could quite easily be modelled. You just assume that Trump's or market participants' actions are a shock which influences prices. This shock changes the price in one moment, than the price itself exudes a shock on market participants or Federal Reserve Chairman's beliefs, they adapt, change their beliefs and again exude a shock on the market. The markets are in constant flux or change. George Soros never mentions Bayesian statistics, so I am not sure whether he is familiar with these methods. Bayesian statistics models the current state of events as the prior, which the new information changes, so the prior changes and the posterior results change. Then the prior changes again and so on... The problem with all this is that with democracies and free markets you never quite know what effect Trump or Jay Powell's actions will have on the market. You do not know the shock outcome. But yes, reflexivity theory is not very difficult to put into models.
The Efficient-market hypothesis. Ah, that great academic construct. To put it straight, there are at least 30-40 portfolio managers whose track record in managing investments disprove the Efficient-market hypothesis. As far as I am concerned, a portfolio manager needs to beat the market in at least 5 from 10 years to make the Efficient-market hypothesis invalid. There have been MANY occasions on which portfolio managers have disproved Efficient-market hypothesis. Warren Buffet, George Soros, Bill Miller, Benjamin Graham, Seth Klarman, Joel Greenblatt, Philip Fisher are just some of the most famous examples. Let's take a deep dive. Why is the Efficient-market hypothesis not true. First, it is very difficult to test the truthfulness of the Efficient-market hypothesis. Second, the Efficient-market hypothesis assumes that the aggregate market participants' views are always correct and there is no way to extract 'abnormal' profits. Basically, the Efficient-market hypothesis assumes there is GOD who knows all- God is the aggregate market participants' views, which are ALWAYS right. Why is this NOT true? Anyone who has invested in the markets knows why. There are simply too many frictions. Market participants DO NOT have the same information. What is more, in the Efficient-market hypothesis there are the implicit classical assumptions of classical economics that people are always rational and Supply and Demand are given or exogenous. Basically, that is NOT true. The iPhone supply created its OWN demand. Supply constantly influences Demand and Demand constantly influences Supply. Kahneman and Tversky, Arielly and Richard Thaler have pretty clearly documented that human beings are not always rational, especially in the short term.
To put it in a one single sentence:
YES. IT IS POSSIBLE TO EXTRACT ABNORMAL PROFITS FROM FINANCIAL MARKETS. CONSISTENTLY. PERIOD(.)
Where does that leave classical economics? I am a classical economist in the sense that markets always know better than a single person or dictator. I am a free marketeer. I believe there should be minimal government intervention. I believe there should be both state and private hospitals and universities, where people could choose according to the financial means they have. However, I am Keynesian in the sense the regulators should get involved from time to time to correct the markets' excesses. Why? Because unbridled greed could cause severe damages to the capitalist system in the short run. Yes, as George Soros says, hunans are always fallible, their knowledge is imperfect, but society is after all a human construct.
P.S. Hats off and deep bow to the Chicago School of Economcs and Eugene Fama who developed the
Efficient-market hypothesis and the Columbia Business School which since Benjamin Graham has contended that markets can be predicted and abnormal profits can be extracted from financial markets. I have always dreamt of studying in such universities!
George Soros wonders why his theory of reflexivity has not gained enough traction in both academic and practitioner circles. One explanation is that the theory is difficult to model, according to Soros. That, actually, is not true. Refelxivity theory could quite easily be modelled. You just assume that Trump's or market participants' actions are a shock which influences prices. This shock changes the price in one moment, than the price itself exudes a shock on market participants or Federal Reserve Chairman's beliefs, they adapt, change their beliefs and again exude a shock on the market. The markets are in constant flux or change. George Soros never mentions Bayesian statistics, so I am not sure whether he is familiar with these methods. Bayesian statistics models the current state of events as the prior, which the new information changes, so the prior changes and the posterior results change. Then the prior changes again and so on... The problem with all this is that with democracies and free markets you never quite know what effect Trump or Jay Powell's actions will have on the market. You do not know the shock outcome. But yes, reflexivity theory is not very difficult to put into models.
The Efficient-market hypothesis. Ah, that great academic construct. To put it straight, there are at least 30-40 portfolio managers whose track record in managing investments disprove the Efficient-market hypothesis. As far as I am concerned, a portfolio manager needs to beat the market in at least 5 from 10 years to make the Efficient-market hypothesis invalid. There have been MANY occasions on which portfolio managers have disproved Efficient-market hypothesis. Warren Buffet, George Soros, Bill Miller, Benjamin Graham, Seth Klarman, Joel Greenblatt, Philip Fisher are just some of the most famous examples. Let's take a deep dive. Why is the Efficient-market hypothesis not true. First, it is very difficult to test the truthfulness of the Efficient-market hypothesis. Second, the Efficient-market hypothesis assumes that the aggregate market participants' views are always correct and there is no way to extract 'abnormal' profits. Basically, the Efficient-market hypothesis assumes there is GOD who knows all- God is the aggregate market participants' views, which are ALWAYS right. Why is this NOT true? Anyone who has invested in the markets knows why. There are simply too many frictions. Market participants DO NOT have the same information. What is more, in the Efficient-market hypothesis there are the implicit classical assumptions of classical economics that people are always rational and Supply and Demand are given or exogenous. Basically, that is NOT true. The iPhone supply created its OWN demand. Supply constantly influences Demand and Demand constantly influences Supply. Kahneman and Tversky, Arielly and Richard Thaler have pretty clearly documented that human beings are not always rational, especially in the short term.
To put it in a one single sentence:
YES. IT IS POSSIBLE TO EXTRACT ABNORMAL PROFITS FROM FINANCIAL MARKETS. CONSISTENTLY. PERIOD(.)
Where does that leave classical economics? I am a classical economist in the sense that markets always know better than a single person or dictator. I am a free marketeer. I believe there should be minimal government intervention. I believe there should be both state and private hospitals and universities, where people could choose according to the financial means they have. However, I am Keynesian in the sense the regulators should get involved from time to time to correct the markets' excesses. Why? Because unbridled greed could cause severe damages to the capitalist system in the short run. Yes, as George Soros says, hunans are always fallible, their knowledge is imperfect, but society is after all a human construct.
P.S. Hats off and deep bow to the Chicago School of Economcs and Eugene Fama who developed the
Efficient-market hypothesis and the Columbia Business School which since Benjamin Graham has contended that markets can be predicted and abnormal profits can be extracted from financial markets. I have always dreamt of studying in such universities!
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Kind regards,
Petar Posledovich
Conflicts of interest: I may possess some of the securities,currencies or their derivatives mentioned in the blogpost and posts on social networks(Twitter, LinkedIn etc.)!
Kind regards,
Petar Posledovich
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