A Different Way to Look at Things
The world of finance, as we know it, is going through a turmoil of changes. After the market crashes in the prominent financial hubs of the world, the fiasco of subprime mortgage loans, the bankruptcy of American International Group and other big corporates, there have been many speculations, conspiracy theories and explanations going on.
Although these theories and conspiracies have had their share of differences, most of them came to agree on one simple point – efficient market hypothesis is not that efficient to predict individual performances of an investor in the market, and neither very accurate to predict overall market movements. This has brought about few fundamental differences in the way an investor and an investment is looked into. This article discusses two such contemporary issues – The Flaw of Averages and the area of Behavioral Finance.
The Flaw of Averages, propagated by Dr. Sam L. Savage, is actually not radically different from the classical portfolio theory or the efficient market hypothesis. It just highlights a failure in understanding the underlying mathematical principals of the risk management tools – mostly the overuse of the average. The concept claims that when you consider an average return or an average revenue, the average comes along with a spread, a distribution, and instead of focusing too much on the averages, we should have risk policies that take into consideration the spreads.
It highlights the importance of having an intuitive understanding of the risk management concept, pointing out that many complex tools did indicate financial meltdown, but they were beyond the intuition of the user to understand, thus the warnings were never received. It propagates the field of probability and distributions, with the logic that if the investors and finance managers in large corporates can have a better idea of the possible outcomes and probabilities of them occurring, the future will look less bleak for finance. The book prophesizes the rise of Probability Management, a system where financial models will not use just numbers as assumptions but will use spreads, distributions as assumptions and generate forecasts of a spread of possible events and then strategize for those events.
Another similar modification to efficient market hypothesis was through the area of Behavioral Finance, which borrows the basic concepts of behavioral economics. The origin of these concepts have been long back, when Daniel Kahneman and Amos Tversky in their pioneering work showed the world that though many economic theories assume the human decision maker to be rational, in reality the human decision does suffer from a good number of biases. They can be influenced by the wording of a decision problem, they try to answer a complicated question by coming up with an answer to an easier question, they tend to be more sensitive to lose something when they already have it, and more reckless when they don’t have it and many such anomalies. These are termed as biases. The work of these men showed that human beings cannot be always pictured as cool headed beings, unaffected by a context, emotion or others influences, maximizing his/her own utility. In fact the studies showed that human beings can be very irrational, both in their personal lives and also in their work life. This finding brings into question all the economic, decision and financial models that base themselves on an assumption of rationality from the decision maker. Although many of the economics model are still the closest approximation of real life in a macro model, in an individual micro level, many such models fail. Thus the field of behavioral economics became more and more popular, and many of the biases that prevail in the field of behavioral economics made themselves known in the field of finance as well. Many of the causes of the financial crises could actually be attributed to these biases in an individual basis. The field of behavioral finance recognizes that although in many cases the efficient market hypothesis is still being accurate, a better understanding is required of the individual investor, his/her biases, and the possible set of factors that affect the individual’s decision making. Through this understanding, many movements and anomalies in the market can be identified, and such understanding can lead to better investment behavior.
The article just covers two new ways to look into finance and investment, amongst many others that are out there. The reason I am discussing these two is because they have been equally promising in coming up with logical and intuitive models of why the markets failed and also because both address areas that has not been extensively addressed by other financial models. I am not sure and not ready to argue that which of these approaches has a better future, or a better conceptual future, but I would like to point a simple fact – the field of finance is changing, the way we look at an individual investor has changed drastically over time, and there is more stress on intuition and simplicity of model in recent times.
By
Khan Muhammad Saqiful Alam
K. M. Saqiful Alam is a lecturer for Department of Management, School of Business, North South University. After completing his undergraduates from Institute of Business Administration (IBA), he finished his masters from Manchester Business School, and has been in the field of academia for almost three years. Other than taking classes in risk management, operations management and applied statistics, he is also involved in training, taking sessions on supply chain and process mapping. Also he has published few articles, on the field of risk management and decision making.
