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November 08, 2004

Four Schools of Thought - One Conclusion

There are quite a few schools of thought among academics who do research in finance and investing. The four main categories, or paradigms, are the University of Chicago school, chaos theorists, the behavioral finance school, and the socionomics paradigm.

 

Each of these groups of academic researchers view, and explain the financial markets in a very different way. And yet, each of them come to one very similar conclusion - that markets cannot be predicted consistently over long periods of time.

 

The "Chicago economists" are so named because Dr. Eugene Fama, of the University of Chicago, first put forth the idea of efficient markets and random walk theory in stock prices in his PhD dissertation back in the 1960s. This is the oldest and most widely accepted of the different market paradigms and the basis for most of the higher education curricula in finance.

The Efficient Market Hypothesis states that at any given time, security prices fully reflect all available information. The implications of the efficient market hypothesis are meaningful, yet lost, on most investors.

 

"Most individuals that buy and sell securities (stocks in particular), do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the selling price. But if markets are efficient and current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill."

 

The random walk theory was first proposed by Fama, and later popularized by Burton Malkiel in his book, "A Random Walk Down Wall Street." RMT asserts that price movements will not follow any patterns or trends and that past price movements cannot be used to predict future price movements.

 

Much of the original theory on these subjects can be traced to the 1900 PhD dissertation of the French mathematician Louis Bachelier. While largely ignored at the time, it is now the basis for much of the theory related to the predictability of stock prices. Bachelier's conclusion was that "The mathematical expectation of the speculator is zero."

 

Chaos theory and fractal finance reach the same conclusion, but in a very different way and for very different reasons. The father of fractal finance is Dr. Benoit Mandelbrot. In his book, the Misbehavior of Markets, he says:

 

“Efficient Markets theory is elegant but flawed, as anyone who lived through the booms and busts of the 1990s can now see. The old financial orthodoxy was founded on two critical assumptions in Bachelier’s key model: Price changes are statistically independent, and they are normally distributed. The facts, as I vehemently argued in the 1960s and many economists now acknowledge, show otherwise.”

 

A very key point in the work of chaos theorists is that stock prices do not fall in the bell curve or normal distribution. If they did, you should be able to run any market’s price records through a computer, analyze the changes, and watch them fall neatly into a cluster around the average.

 

In fact, says Mandelbrot, the bell curve fits reality very poorly and anyone who has invested for any long periods of time knows this to be true. The bell curve would say the sorts of dramatic price movements we see every day, like a stock dropping from 50 to 20, should be almost impossible. Instead, Mandelbrot argues the stock prices move based on power laws.

 

In his book, Mandelbrot describes five “rules” of market behavior that derive from his work using fractals to model financial asset prices. Among them is that markets mislead. In other words,

 

"Patterns are the fool’s gold of financial markets. The power of chance suffices to create spurious patterns and pseudo-cycles that, for the entire world, appear predictable and bankable. Financial markets are especially prone to such statistical mirages. Contrary to conventional thinking in finance and economics, bubbles and crashes are inherent to markets. They are the inevitable consequence of the human need to find patterns in the patternless."

 

I will pick up my description of the four schools of thought tomorrow and finish with behavioral finance and socionomics. In the meantime, if you want to have a deep understanding of the financial markets, I highly recommend Dr. Mandelbrot's book. You can find it, and a link to listen to my interview with him, on my web site in the recommended reading section.

 

SOURCES:

 

1. Investor Home, "The Efficient Market Hypothesis & the Random Walk Theory," http://www.investorhome.com/emh.htm, 8 November 2004.

 

2. Bernstein, Peter. Capital Ideas. New York: Free Press, 1993.

 

3. Mandelbrot, Benoit, and Richard L. Hudson. The Misbehavior of Markets. Basic Books, 2004.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

 

Posted by Kim Snider on November 08, 2004 | Permalink

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