Why the Apparatchiki of Finance Didn’t See It Coming

[Joanne98]

March 7th, 2009 by Patrick Byrne
I know a great joke. Unfortunately, I’ve learned that few people get it without a preface.

So here’s the preface: In the 1950’s there was a school of psychology called “Behaviorism”. Behaviorists turned away from the “internal states” that had been the concern of psychology since its inception, regarding them as mental constructs whose explanation invoked unscientific mysticism. Behaviorists instead proposed a new “scientific” paradigm and mission: to describe “the organism” in terms of inputs to and outputs from a Black Box whose inner workings need not be explained. If you have seen 1950’s grainy black-and-white films of BF Skinner teaching pigeons to spin around and peck buttons, and chickens learning to perform simple tasks, you have seen Behaviorism in action.

So here’s the joke: Two professors of behaviorist psychology have sex. When they’re finished they lie back and light cigarettes. One says to the other, “So…. That was good for you. How was it for me?”


It’s a great joke. For those who still missed it, the point is that the professors were so wrapped up in their theory (in this case, the denial of internal states), that they could not experience what was right in front of them. They had to filter their data through the theory to which they were committed before they could experience it.

Sometimes such commitments bind their holders so strongly they forget that what they are committed to are just paradigms. For example, Richard Feynman told a story about how, in 1895, the chairman of the Harvard Physics Department discouraged new graduate students from starting PhD’s on the grounds that all the questions of physics had been answered, with the exception of two problems. Those two problems were the photoelectric effect and the problem of black-body radiation. Their subsequent investigation spawned relativity and quantum mechanics, shattering the classical Newtonian paradigm to which the Harvard department chair had been committed.


Modern finance theory is dominated by two pillars: the “Capital Asset Pricing Model” (or “CAPM”) and “Efficient Market Theory” (or “EMT”). CAPM is a model that says, Market participants will bid the price of a financial asset up and down until its return and its volatility satisfy a certain equilibrium equation. Efficient Market Theory evolves alongside of CAPM to say, Prices have already been so bid to reflect all publicly available information.

An implication of Efficient Market Theory is that, since securities are already priced to reflect all publicly available information, it is impossible to beat the market without having inside information. While for some years the leading edge of finance theory has been nibbling away at EMT, it is no exaggeration to say that it is still the dominant paradigm of modern finance, and that every MBA program in American universities teaches EMT as the core of finance theory.


By happy accident I was exposed to EMT by its greatest counterexample, Warren Buffett. I was 14 when he impressed upon me the ridiculousness of EMT. He loved the fact that it was taught in business schools, he said, for it made his job “like playing bridge with people who have been told it doesn’t help to look at the cards.” Later, I was fortunate also to know Dr. Kenneth Arrow (one of the founders of general equilibrium theory, and the originator of Arrow’s Impossibility Theorem, a tidy social choice proof he did over a weekend when he was 26 for which he later won the Nobel Prize). Dr. Arrow also ridiculed Efficient Market Theory to me, saying, “Believing in EMT is like believing you can’t find a $20 bill in the street because if it were there someone else would have picked it up already.”

Mr. Buffett and Dr. Arrow warned me about the intense dogmatic belief in Efficient Market Theory among finance professors. Mr. Buffett compared their profession to a Mayan priesthood whose practitioners had invested years in learning the arcane language of their priest craft (or as he put it with regard to finance professors, “had gotten their Ph.D.’s learning how to talk to each other in Greek letters”). He pointed out how natural it was for priests to defend the hard-won skills which set them apart from ordinary mortals.

Continued>>
http://www.deepcapture.com/why-the-apparatchiki-of-finance-didnt-see-it-coming/

[HamdenRice]

1. I can say with first hand experience that EMT is bullshit

because at one time in my life I used to write disclosure documents for corporations that were filed with the SEC. These documents are called prospectuses and registration statements. It is these documents that theoretically provide the information that the "efficient markets" use to price the securities.

The problem with the theory is that the documents are simply too complex for any person (really most people including MBAs and PhDs) to understand and make market decisions based on. I had to try to understand them because I was writing them. Almost every prospectus or registration statement is based on some earlier prospectus or registration statement because no human could write one from scratch in a reasonable amount of time.

Before even beginning, I would have to lock myself into an office and decipher an example of one. It might take weeks of 16 hour days. I would have to elaborately diagram sentences because I couldn't figure out what the fuck the earlier writer was trying to say because the stuff the prior writer was writing was so complex. I would diagram flows of cash and priorities of bond holders.

Even then, I only did part of the job. The job of producing these things was rigidly divided between the finance guys, the accountants and the lawyers. No one could understand each other's work -- hell we could barely understand our own.

And the prospectus/registration statement was the tip of the iceberg. It was maybe 150-200 pages. But the corporate client was also required to publish "exhibits" which were the most important contracts of the corporation bearing on the projections of profit and loss in the prospectus. These exhibits might be 5,000 pages of dense legalese.

For the EMT to work, people trading stocks and bonds would have to have read all this material and figured out what it means for a complex corporation's bottom line. No one did. There was an especially stupid corollary to the EMT -- which was that some perhaps imaginary other people did read the stuff and were sending market signals that other investors could use -- kind of like someone else did his homework so I'll just listen to the smart kid's answers.

Warren Buffet became a billionaire by being the only guy who read all that stuff diligently and understood it, and invested based on that understanding.

I'm not a "we're number one, USA! USA!" kind of guy, but I can say that no other government has ever tried to make as much information available to investors as the system that FDR set up when he created the SEC. We actually had (despite what many DUers think) an amazingly transparent financial system -- better than any in the world.

I say had, because I stopped doing this work during the late Clinton years when the SEC was hardass and would actually make you disclose everything and then still might say, "nah, so soup for you." The joking term for what you had to do to a company was "give it a due diligence enema."

The problem with our system, even when the SEC did its job, is that the companies are simply too complex for any human being to understand, and therefore their stocks and bonds are too complex for anyone to understand as well -- even the simplest common stock because it represents a company that's too complex.

There is too much information that cannot be organized or understood by any human brain, and I'm not sure what the long term answer is. Probably much smaller disaggregated companies is the only solution. If your company makes ball bearings, it should not be bundled up with a company that makes medical devices, because when you do that you add to the complexity of understanding the ball bearing business.

[upi402]

3. Oh my god

You're a riot, thanks so very very much.

I just took macro and micro econ in college. I figured "economics" was utter bullshit. A foundational premise is that; people will act in their own best economic interest. Ha! So, why do firms spend on advertising and why do credit cards exist, I thought. People are easy to fool if you can pay for the TV ads.

[anigbrowl]

4. I was much taken with Volcker's recent observation

that the widespread deployment of ATM machines and debit cards probably did more for economic growth than any cleverly-designed financial instrument ever has or will. Have you read 'Bullshit Promises'? It's an academic paper on the the same phenomenon in consumer contract law, which notes in passing that the standard credit card contract now requires the equivalent of a PhD reading level to parse correctly.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1262477 if you haven't seen it, it's a real hoot.

[upi402]

2. Time for Hari Seldon to depart Trantor, fast!

Seeing this coming and stuck without the resources that would give me options has made me furious. And the blind dolts that got us into this still ranting against the Novocain and extraction and ensuing bill... well my jaw is tight from here.

In Asimov's Foundation trilogy it was the psycho-historians that were the oracles. In Gawbless'murica land you are unpatriotic if you state facts that contradict the corporatist line.

I'm thinking of renting out my house, (demand here is high for rentals) and hope the rents from it pay for the house AND a cheap apartment in a low cost country. I may withdraw whatever I can from my annuity and pension early, and go. Too sad, I played by the rules and worked very hard every damn day.