Top 4 assumptions that cause market failures

Many articles have been written (including my blog post) and much ink has been spent on this topic. Let’s now have a cursory look at the history of modern finance, which will help explaining how modern finance works, hence how the regular market crashes/failures (by the way, have a look at an excellent round-up economic history of finance and market failures by John Cassidy; also check out the article about the three recent Nobels for explaining market failure from an unemplyment perspective) happen.

You might or you might not know, but the modern financial theory is built upon a legacy of a son of a French wine merchant and diplomat,  Louis Bachelier. His doctoral advisor was Henri Poincaré, one of the most celebrated and influential mathematicians of all time. The defense of his 68-page thesis, “Théorie de la Spéculation,” took place in March 1900 and was about trading of government bonds on Paris exchange. In his thesis, he laid the foundations of financial theory, and more generally, for all theories of probabilistic change in continuous timeframe. The cornerstone of his thesis was to explain how the prices change.

Bachelier died unknown as his thesis was respectfully discarded in the annals of French academia and only by accident discovered in 1963 by Eugene Fama, the creator of Efficient Market Hypothesis, the foundation of the orthodox financial theory. What he proposed – and the his proponents Markowitz, Sharpe, Black and Scholes elaborated on – was a coin-tossing model of finance. He assumptions can be formulated as follows:

  1. People are rational (if this were true, there would be no science of behavioural economics)
  2. All investors are/think alike (ignoring different types of investors)
  3. Price changes are practically continuous (of course prices jump in a discontinous manner – almost every day, NYSE reports “imbalances” due to exogenous changes)
  4. Price changes follow Brownian motion (Bachelier proposed to use Fourrier formula of heat spreading to describe how bond prices change)

A little further elaboration on point #4. Bachelier’s adaption of Brownian motion had three critical implications: independence (prices last day/week/month have do not influence prices today); statistical stationarity (prices change in the same manner in the past/present/future); normal distribution (price changes follow Gauss’ bell-curve). The third implication, which underpins almost every tool of modern finance,  is the one most obviously contradicted by the facts.

Ever since rediscovery, utilisation and expansion of his theory in 1960s, Bachelier’s ideas found their way into virtually every aspect of modern financial theories. Capital Asset Pricing Model (one study suggested that about 75% of financial managers/CFOs use it to estimate cost of capital), Modern Portfolio Theory (the most widepsread method of selecting investments) and Black-Scholes formula (for valuing options contracts and assessing risk) are the three pillars of modern orthodox finance theory. All three are part of every MBA curriculum and are translations of Bachelier’s ideas into practical tools.

The above (wrong, or in the best case, narrowly applicable) assumptions being at the core of every modern financial tool, it is clear why markets failed and will continue to fail, unless a radically new approach, a paradigm shift takes place in the financial market. This tectonic shift has already started taking place…