Financial Models Determine Trends

The attempt to rationalise the behaviour of markets has yielded many financial models which are now being criticised as being a primary source of the financial crisis of the past 2 years. Regardless of whether these models were adequate as a reflection of market behaviour, I believe that the use and adoption of these models had an important role in the impact of financial crises of the past 20 - 30 years.

I believe that the adoption of the popular models for rationalising market behaviour (such as Black-Scholes, Value-At-Risk, CAPM and various Pricing Theories) by large portions of the market players made the basis for decision-making close to uniform in influential segments of the market such as large pension funds and mutual funds. The resulting decisions and bets on stocks and derivatives were geared in one standard direction on the basis of the outputs of these models. Consequently, the average uniformity in decision-making arising from positive outputs from these models would have driven sustained increases in asset prices over months and years since the market participants would have been using very similar outputs from their models. Similarly and importantly, unique negative shocks, events and shifts in sentiment would have created a uniform set of decisions in the opposite direction causing a crisis and further, as Kahenman and Tversky have proven in their research, losses loom larger than gains and therefore probably fed downward spirals, independently of the models themselves.

Revised and new models arising out of the learning from the latest financial crisis, I suspect, will not solve these problems but rather create the similar patterns of gains and losses over the coming 30-40 years though driven by different market factors input into these models, with a large crisis yet again in this period. The ability to predict and model human and market behaviour is a very long way off.

Is risk really risky?

The traditional view of risk and return is that an investor's or entrepreneur's returns is related to the type of risks he or she takes. If he or she takes a large number of high risk bets, the overall returns should be large. As their stories go, well-known and successful investors and entrepreneurs such as Bill Gates, Richard Branson, Muhammed Yunnus and George Soros have tread unconventional paths and made bold decisions which have determined their success. But while general society views their stories as a set of bold and risky decisions, in their eyes were their decisions risky? I believe not - that is to say, to these investors and entrepreneurs, these decisions were very simple to make because, to them, the outcomes were certain.

If these entrepreneurs and investors have a unique way of understanding information which enable them to get a strong "feeling" about the future - a "feeling" which tends towards certainty - then their decisions would be almost based on certainty. Many of these types of people talk about their "gut instinct" and just "going with the flow" and these inclinations are what led them to their success. The decisions made would be viewed as risky and foolish by the average person at the point in time when the decision was made but perhaps the abilities of these investors and entrepreneurs enabled and enables them to process and assimilate information that led and leads to degrees of certainty about future events that the general society or the average person cannot see. Is it that the abilities of these investors and entrepreneurs allow them to see into the future in a way that enables decisions to be made based on a unique view of trends, events and outcomes that tends towards near certainty? I believe so, and further, if someone else had taken any of same decisions as any of one of these unique investors or entrepreneurs, the outcome would not have been the same as the understanding that converts the uncertainty into certainty would have been absent in the average person.

In that case, to try to emulate the strategies, decisions and paths of very successful investors and entrepreneurs is like chasing wind.