Investment practitioners have all too readily given up the high ground when it comes to formulating theories on how financial markets work. Perhaps because practitioners have been too engaged actually making money in the markets by employing realistic theories, most financial theorizing—for reasons that are obscure to me—has been left to academics. Many financial theories have no doubt been hatched in an attempt to gain tenure rather than actually having to be employed in the marketplace to make money.
Here’s what George Soros had to say about efficient markets in an interview about the financial crisis:
It is important to realize that the crisis in which we find ourselves is not just a market failure but also a regulatory failure, and even more importantly, a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse.
Pretty harsh. Mr. Soros has an alternative theory of how financial markets work that he calls reflexivity:
I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend toward equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, “The Alchemy of Finance,” in 1987. It was generally dismissed at the time, but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.
Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced…
Second, financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified. I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921, but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.
Perhaps not shockingly, Mr. Soros thinks that markets trend. Hmm…George Soros a trend follower? Who knew? Here’s how he describes the market process:
Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia…Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.
Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.
Let’s see: markets trend. First markets trend slowly for logical reasons, then the trend accelerates, eventually for illogical reasons. Then the market reverses sharply when reality is recognized once again, culminating in a panicky selloff.
That is pretty much the story for every monster investment theme throughout history. You already know this if you’ve been around markets and have been clever enough or lucky enough to catch a few rockets. You don’t even have to believe the theory—you can actually observe this happening over and over.
Now Soros doesn’t claim his theoretical model is absolutely right—just that it is better than the academic models currently in vogue. Since he came to America as a penniless immigrant and has managed to make $14.5 billion, I am going to go out on a limb and say that perhaps he knows more about it than most academics. At least I do not know of any academics who made $14.5 billion by means of modern portfolio theory. (Warren Buffett also regularly mocks modern portfolio theory and has managed to make a fortune using his personal theory of how markets operate.)
Somewhere in here, don’t you have to conclude that markets are not efficient and modern portfolio theory is bunk? If not, seriously, where is your proof that you can make hordes of money employing modern portfolio theory?
Note: If you haven’t read The Alchemy of Finance, it is worth a look, especially for the one-year trading diary of the Quantum Fund.