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.