›  Opinion 

To predict or to adapt?

According to Fabrice Foy, Quantitative Analyst at CCR-AM, we should do the exact opposite of the classical theory: the stock price does not reflect fundamentals, and if it deviates from its fundamental value, it does not necessarily tend to revert ...

Article also available in : English EN | français FR

Beginning of the twentieth century, the formulation of the uncertainty principle is a revolution comparable in scope to the one of the universal laws of mechanics and gravitation by Newton three centuries earlier. It is essential to use a new description of the world. This is such a major change in Physics that it ends the scientists’ old dream to provide a fully deterministic model of the universe. Indeed, we cannot try to predict events if it becomes fundamentally impossible to measure the present state of the universe.

At this stage, we should reassure our readers. We are not leading researchers in theoretical physics but merely portfolio managers. Our modest knowledge of quantum mechanics dated back to our studies or are based on synopsis of some popular scientific articles. However it was tempting to take a small walk through the evolution of modern physics during the past century and the resulting paradigm shift, because similarities with finance are striking.

The financial crisis which started in summer 2007 to reach its peak with Lehman's bankruptcy was an opportunity to question ourselves about finance as a whole
Fabrice Foy

To make the market randomness intelligible

First recall first that all the work of financial economics at least since Louis Bachelier’s thesis (1900), was to develop a theoretical framework to understand market randomness. There followed almost a century of efforts with a strong concentration of Nobel Prizes (Markowitz, Miller, Modigliani, Samuelson and Sharpe). This collective effort that ultimately led to a rigorous and elegant formalism in the early 80s. From a small number of assumptions, neoclassical finance has succeeded in unifying a rich set of results (CAPM formula, Black-Scholes formula or Modigliani-Miller theorem) in a single theoretical framework: Efficient Market Hypothesis. Also point out, for your information, that the efficient-market hypothesis asserts that prices follow a random walk and instantly change to reflect new public information which are themselves assumed to be unpredictable . This formal and undeniable success has allow some to say that neoclassical finance is "the most scientific of all social sciences"(Ross, 2004). Disadvantage: the process, whose purpose was to describe finance with a mathematical precision, had an unexpected effect. It became a field of exploration entirely devoid of human presence.

the observation of a state, that each of us can make, has a set of bias and our view of the world is never completely identical to the true state of this world
Fabrice Foy

Ultimately, the financial crisis which started in summer 2007 to reach its peak with Lehman’s bankruptcy was an opportunity to question ourselves about finance as a whole, including its foundations and its operation. A columnist for the Times, Anatole Kaletsky, on february 9, 2009 published a paper in which he warned: "Now is the time for a revolution in economic thought! [...] Academic economics has been discredited by the crisis" According to him, we need a new paradigm shift comparable to the revolution in physics the early of the twentieth century after Planck and Heisenberg launched quantum mechanics. "More realistically, economics today is where astronomy was in the 16th century, when Copernicus and Galileo had proved the heliocentric model, but religious orthodoxy and academic vested interests fought ruthlessly to defend the principle that the sun must revolve around the Earth"

Our vision is biased

Here comes the parallel with quantum mechanics. He finds an interesting support in behavioral finance: the observation of state, that each of us can make, has a set of bias and our view of the world is never completely identical to the true state of this world. George Soros, well-known manager of the Quantum Fund, wrote in 1998 in "The Alchemy of Finance": "In order to get close to knowledge, we should be able to distinguish between subject and object. However, in our case, the two are one. "

Soros pointed out here a fundamental dimension: our vision has a bias in fields in which individuals are embedded into observed object. The idea applies as well to natural and social sciences, while the hard sciences and natural sciences in general are spared, since the observer is not part of the observed object. Thus, although it is always possible to make observational errors while applying these sciences, the natural process of things remains, however, unchanged. In other words, an false explanation of the mechanism behind cyclones, for instance, does not affect their existence, as well as the assertion that the earth is flat has no effect on its factual rotundity.
In social sciences, especially in financial economics, it is quite different. The facts are always subject to interpretations which have an effect on the reality itself. This is the principle of reflexivity, a term chosen by Soros to describe the process of shifting back and forth between description and action. Il has two components: a perception bias and an action bias.

our vision has a bias in fields in which individuals are embedded into observed object
Fabrice Foy

Markets are inherently unstable

This concept explains the financial markets’ instability through a combination of three mechanisms:
- The business fundamentals. The stock price is certainly far from reflecting only fundamentals. However, they must be taken into account as an "underlying"
- The perception bias,
- The action bias, which may in turn change perception and fundamentals.

Thus, the back and forth between biases lead to inherently unstable markets. This instability produces a perpetual and open process,a recursive process, in short a historical process! It is also interesting to note that even if according to the law of nature, recursive movements result in a deterministic chaos, it is not the same in finance, where the lack of equilibrium similar to the stability of laws of Physics leads to a "quantum" chaos.

It is therefore necessary to have a good knowledge of the distortions that exist between fundamentals and their market perception
Fabrice Foy

Take into account investor psychology

It is really about doing the exact opposite of the classical theory: the stock price does not reflect fundamentals, and if it deviates from its fundamental value, it does not necessarily tend to revert. Therefore, an investment decision based solely on fundamentals seems risky. It is necessary to have a good knowledge of the distortions that exist between fundamentals and their market perception. This is the path chosen by behavioral finance, based on assumptions including investor psychology. We turned it into ??an investment philosophy. And just as the "quantum" revolution in physics has revealed the impossibility of a complete prediction of the future, we believe, given the inherent complexity, uncertainty and unstability of financial markets, that adaptability and flexibility are the essence of our role as asset allocation managers

Fabrice Foy , March 2011

Article also available in : English EN | français FR

Read also

March 2008

Interview Nassim Taleb « portfolio theory: it’s a bit what astrology was to our ancestors »

Empirica LLC founder and author of best seller Fooled by Randomness, Nassim Taleb, answered the questions of Next-finance in an exclusive interview.

March 2007

Note Towards a behavioral portfolio theory

a major problem facing the asset management industry is the creation of portfolios that generate maximum profitability while being consistent with the risk profile of investors...

Share
Send by email Email
Viadeo Viadeo

Focus

Opinion Psychology and smart beta

‘Smart beta’ sounds like an oxymoron. How smart can it be to continue using the same strategy in such fickle markets? A portfolio manager calling on all his skills (‘alpha’) in analysing market environments (the source of ‘beta’) should be able to outperform an unchanged (...)

© Next Finance 2006 - 2020 - All rights reserved