Sep 23 2009
What 9.11 Attack and the Financial Crisis Have in Common
Continuing from yesterday long blog. Bill added the comment that “Stock market is far from being rational”. I can see where he comes from, but I don’t think we can dismiss the entire “efficient market hypothesis” (EMH) because of this crisis. After all, there is solid theoretical and empirical foundation underlying EMH, e.g. the decision market experiment and the asymmetric information theory, etc.
Instead, I’d posit that it is reasonable to compliment EMH with Soros’ Reflexivity: in normal times when there are competing sources of information that result in widely distributed asymmetric knowledge islands and none is dominantly more significant than any other, EMH holds. However, under the right condition, the market could become suddenly and increasingly self-destructive. In plain English, it is a time when self-fulfilling prophecy run amok.
In other words, if we call the EMH state a “rational state”, the “Reflexivity” state an “irrational state”, what intrigues me is under what condition would the rational moving irreversibly toward the irrational? It is not quite the same as the “tipping point” where a stable state/system changes into another stable state/system. In this case, it is a point where a stable system suddenly and irreversibly change into a self-destructive system. Or, more to the point here, a rational state into a irrational state.
I may be stretching here, but is it fair to say that American public opinion (or call it collective cognition) experienced a similar transition after 9.11? A shock happened, then a relatively mild stable and rational public suddenly degenerated into irrational fear, which drained the vitality (spiritual and materially) out of an otherwise healthy society?
Even if we don’t get distracted by politics, I still think the question I asked earlier is a significant one. However, I am not sure whether this phenomenon is related to human behavior only or it exists in any system? For example, can we apply this pattern to explain why some species survived evolution but some extincted? Hmm … do we want our financial system to be like cockroaches or dinosaurs?
Another good evening in my life is thus totally ruined.
Interesting and thought-provoking stuff! I need to do some reading on Soros’ investment philosophy to make informed comments about “reflexivity”.
I want to add one more point regarding EMH. A key component of EMH is that the information about a particular company/stock is embedded into the stock price.
But, the more I know about media, the less I trust about media. Looking at the public companies I had been part of, in pretty much all of the cases, the media (e.g. business press, investment analysts, etc.) know very little about what’s exactly going on in the company. One could argue that all of those information (accurate or not) are reflected in the stock price. But, the information is inaccurate at first place!
I agree. Strictly speaking, stock price should reflect the long term cash dividend the owner has claim to. The price is based on projected earnings. The exercise of projection is where perception and forecast meet and mix. I think that is where Soros has a point: the real price is what people think it is. Because the price is so tied to perception, there is not so much an “innate price” than an agreed upon price. He further claims that the convergence on an agreed upon price is in itself very reinforcing (aka self-fulfilling prophecy). At least that is my understanding.
Well, he must be onto something I guess, given how much money he’s made