There are two approaches we could follow while living our life. First is we do things in practical and with our experience we form a perspective. Second is we learn things in books and theory and then try to implement learned perspective in Practical field. In both method its natural to encounter problems and therefore we try to ponder upon them and try to figure out the solution. It’s necessary to understand both method but in certain field one method could have an edge over the other. I Will try to figure out what suits in the field of Financial markets.
Generally, a theory is derived from certain assumptions called axioms. Resting on these axioms a theory tries to explain a process. If theory can explain the process and can predict the happening of event in future, its apt to adhere to theory. In other words, we can say we try to model reality by assuming certain assumptions to simplify reality and then try to use the model for prediction or to comment on the repetition of event. It’s interesting to debate over the plausibility of assumptions/axioms.
Finance has taken approaches of physical science to explain its own processes. There is nothing wrong to use research of one field in others. In fact, this is the way that many great explanations in past were proposed successfully. We take a simple model of atomic structure for our study. It’s been proposed that an atom consist of electron, proton and neutron. Though nobody had seen these entities but assumption of these explained the unsolved problems of atomic structure. If these assumptions go on explaining physical phenomenon we keep faith in them. Let’s take example of gravitation. Newton proposed that apple fall towards ground not vice versa because earth extends force on apple and which is attractive in nature. Again, nobody has seen this force, its hypothetical in nature but none the less it explains the falling of apple. We all know how much human beings gained from this discovery. I guess this was the thought process when William Sharpe in his seminal paper on asset pricing commented that a theory real test is not the assumptions but what it can explain.
Now let’s take one example from Finance. It’s been assumed away in almost all Modern financial theories that an investor can have a fair estimate of the anticipated returns. Moreover, to help the investor these theories recommended certain methods to arrive at value of anticipated returns. So, let’s further get deep in this thinking. Suppose I have a stock in mind to invest in and I estimate the I can get 20 percent return in next one year. In my estimation I have used most sophisticated tools available or recommended by experts. It’s been common experience that there is every possibility that this stock could give away a 40 percent return. Note that I am not saying that there is no chance for this stock to give a 20 percent return. My claim is that a 40 percent return is a possibility you cannot overrule. Firstly, it could be counter argued that it is one off event. But experienced traders know that this is not one-off event on the contrary these movements are all that matters. Secondly, it could be argued that there will always be error in estimation. Right but this is not the error. It is just the double of what we have anticipated. It is not error because it has change the essence of the process due to its huge impact on our estimated value. We can therefore conclude that human beings are not that good in estimation when it comes to finance and our assumption of human beings good at probability is invalid as it cannot model the reality fairly. As a result, the perspective we have formed about finance is also faulty. Why we are good in estimating when it comes to physics is a separate issue that we will ponder upon in our next article.
If you are still with me I expect you to question me that to observe a problem/process in field, we need to have something already in our mind through which we observe. Therefore theory/learning comes first and help us to observe things in practice. This objection of yours is very subtle. But I would like to negate you. I contend that we observe first and then form the theory or explanation. Take the simple example of a child. He does not know any theory but still he learns. He keeps on observing and try to find a theory that could suit his observation. First time my child complains about stomach ache is the product of what I am contending. He does not learn about stomach ache in class room, but he learns it by observations around him.
There are elaborate works by Nobel laurate Daniel Kahneman claiming that human beings are probability challenged. I don’t intend to say that these models are bogus. They are the work of great labor and have certainly many valid points to learn but at the same time they have misdirected in our endeavor to understand finance markets and processes. Further the cost of this misdirection is heavy.
Let’s start again from where we have started. If we have gone from practical to theory I guess we could have avoided this problem. As a trader having a decade experience, I find myself eligible to say in trading I am completely probability challenged. Sometimes I underestimate the return and sometime overestimate. Rarely I find myself near to what I intended to do. I will contend that we should not even use word ‘estimate’ because estimation can be done where errors are small and irrelevant, but these errors are my butter and bread. These unexplained movement in prices what makes my trading overall profitable.
So, I rest here by saying that when it comes to finance better to get dirty your hands in field.
Thanks for having to bear with me.Any serious Practitioner critic is more than appreciated.
Your email address will not be published. Required fields are marked *