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HAGSTROM Since his origin, man has been an embodiment of curiosity; his curiosity has led him to look for answers to his being, nature, and environment through the discovery and acquisition of knowledge. This curiosity led to the discovery of science as the study of the physical and natural world and phenomena, especially by using systematic observation and experiment (Encarta, 2008). In the cause of time, even science as a whole proved to be insufficient to satisfy his curiosity and craving for knowledge, and as a result was broken into different disciplines and branches of study that focused on particular specializations with respect to the ideologies of different schools of curiosity (or thought). After so many years, these branches have been divided into even more branches as systems evolved and new ideas were adopted; amongst these new areas of study, finance has evolved as a science that describes the management of money, banking, credit, investments, and assets (Investopedia, 2008). As the financial environment has become more sophisticated, new approaches and models to thinking have also evolved to offer explanations to the complex occurrences in the financial environment. The main challenges in this area had always been how to comprehend the mechanism of the markets with the workings of the economy. As we continue to seek explanations and patterns to the occurrences in our financial environment, more concepts and models continue to evolve. Hagstrom’s latticework of mental models attempts to answer some of these questions by adopting a reverse approach; it does this by explaining the basic concept of finance, economics and markets through the branches mainly consisting of physics, biology, the social sciences, psychology, philosophy and literature. Robert Hagstrom’s latticework of mental models takes us
back to this beginning, bringing it all back to a whole by showing how they all relate to the particular basic concepts in finance. However, in order to totally grasp the concept of the latticework of mental models, a proper definition of the basic terminology would be appropriate. What is really meant by the Latticework of Mental Models? The term Latticework has different interpretations in different fields of study and professional practice: in the construction industry the Latticework is an open framework made of strips of metal, wood, or similar material overlapped or overlaid in a regular, usually crisscross pattern (occasionally latticework has a checkerboard pattern). Latticework is often seen as a component of porches, decks and gazeboes (Beaulieu, 2008). According to the national science, it is an ornamental framework consisting of a criss-crossed pattern of strips of building material, usually wood or metal but can be of any material (National Master, 2007). The two definitions imply an embodiment of other components or constituent of a structure. This is really the basic ideology behind Hagstrom’s Latticework which infers an embodiment of varying components of worldly wisdom. Hagstrom portrays the latticework of mental models as an ancillary of Charles Munger’s approach to analyzing financial markets and investment decisions. According to Charles Munger, the latticework of mental models is simply as an interlocking structure of ideas that is obtained by defining the relationship between the basic concepts of the all disciplines in answering questions or solving problems that could arise on the investment environment; linking these disciplines –according to Munger- is embracing worldly wisdom in its totality. A model can more or less tell you what is going to happen if there are no shocks and structural changes in an economy.
Worldly wisdom according to Hagstrom is that solid mental foundation without which success in the market, or anywhere else is short-lived. However, I would like to say that though attaining worldly wisdom is beneficial, a more concentrated approach to specific fields gives room for specialization, and without specialization their can really be no deep emphatic understanding of the markets. The latticework of mental models is founded on the big ideas of every discipline. I concur with the fundamental view that every field of knowledge is founded from the basic principles of another field, so it would not be totally wrong to say that each one is a fragment of the other with some fundamental unique similarities or patterns; though these unique similarities cannot be manipulated to offer direct interpretation to problems in other disciplines, instead its basic principles are used to develop responses that are applicable to other disciplines and vice versa. Hagstrom portrays finance and the stock market as a part of the general body of knowledge, which incorporates psychology, engineering, physics, mathematics, and the humanities. The field of finance clearly illustrates this assumption; for instance, while there are the behavioral schools of thought in finance and those that are proponents of the Efficient Market Hypothesis; through a broader view of the two schools of thought the theory of the Adaptive Market Hypothesis (AMH) have been propounded. Kurtay (2007) refers to this approach to investment thinking as transdisciplinarily: the conversion of information into knowledge through the mind traveling across various disciplines and reaching knowledge outside the disciplines. Research emerging from a trans-disciplinary approach - continues Kurtay - reflects a true integration and synthesis of knowledge from each discipline rather than a mere compilation of knowledge; it results in truly new perspectives that are more than the sum of parts.
Mental Models in Hagstrom’s view mainly refers to the fundamental concepts adopted from every discipline to guide responses to a set of conditions and random scenarios. In this book, Hagstrom proposes adopting flexibility in the analysis of investment decisions, and in the understanding of the markets; he argues that investment decisions founded on narrow sources of data (restricted to a particular industry) would be inadequate in the assessing all the factors that affect the decision making process. According to Kurtay (2007), Unforeseeable uncertainty can only be dealt with if the decision maker’s response to nature’s moves is not fixed in advance but is itself uncertain. An uncertain response in this context refers to a response that is flexible or customized to deal with particular situations. With the pending financial crisis, businesses have adopted new ways of doing things, with most executives reviewing old policies and introducing new strategy. One major setback with the trans-disciplinary approach is that it is time consuming and therefore could be a waste of time when applied to a project or problem that has no correlation with these basic disciplines. There is a need for the average investor or analyst to view the market from a broader perspective because it results to a flexible approach towards properly analyzing investment data and conflicting opportunities. Lollapalooza effect simply implies that extraordinary rewards are in prospect to those who are willing to undertake the discovery of combinations between mental models. According to Rockwood (2004), the lollapalooza effect occurs when several models in the network combine and are heading in the same direction to produce a given result. In other words, this outcome can be seen as a synergy of mental models that aim at producing a more pronounced effect to the decision that is to be made.
In his book Hagstrom presents a series of models that cover basic areas of knowledge that play a major role in the worldly wisdom. They are as follows: Physics Physics is a complex science that focuses on the study of matter, energy, force, and motion, and the way they relate to each other (Encarta, 2008). This physical science can also be credited for extensive theories to how the universe functions. One of the most important attributes of this physical science – says Hagstrom – is that it seduces us with a sense of certainty and gives us the comfort of absolute answers. This has led many theorists and analysts in an inquiry of the basic concepts and principles propounded in this field of study. Hagstrom attempts to identify the importance of physics and the direct influence of most of its core principles on the mechanism of the economy. His main focus, however, is on the impact of one of the most fundamental theories of physics on the stability of the markets and aggregately on the economy. He illustrates a classical example of combined mental models by focusing on a theory that forms the foundation for the science. Sir Isaac Newton – being one of the founding fathers to the advanced physics propounded the theory of equilibrium; which was derived from combining the laws of planetary motion with the observation that a falling mass accelerates at a uniform pace (Rockwood, 2004). In explaining the basic concept of the laws of equilibrium, Hagstrom establishes a relationship between the law of equilibrium and economics. Most scholars have termed this new field of study that presents such a relationship: “Econophysics”. Econophysics – according to Jurkiewicz & Nowak (2003) - is an approach to quantitative economics using ideas, models, conceptual and computational methods of statistical physics. In recent years many of physical theories like theory of turbulence, scaling, random matrix theory
or renormalization group were successfully applied to economy giving a boost to modern computational techniques of data analysis, risk management, artificial markets, macro-economy, etc. Econophysics became a regular discipline covering a large spectrum of problems of modern economy; and one of such problems is the anomaly experienced in the markets. The theory of equilibrium propounded by Sir Isaac Newton has been used by economists to explain how the markets are supposed to work. According to Rockwood, 2004: One of the products of such resolution is the efficient market theory which states that stock prices and intrinsic values always trade at equilibrium in the market; though this assumption is flawed, it would not be totally inappropriate to state that stock prices trade at their perceived intrinsic value (at least in the short run). He purports that the forces of equilibrium work to maintain a balance between the demand and supply of a commodity (either in form of stocks, bonds or real goods) in the market. With respect to business organizations he concurs with Marshall’s opinion that business firms grow and attain great strength, and afterwards perhaps stagnates and decays; but while this assumption in (in reality) might appear to be true in some business scenarios, it is flawed on several grounds: Firstly, business organization experience a decline in the scale of their operations mainly as a result of ineffective policies and losses to investment and not as a result of some force of equilibrium as could be the case with real goods; Secondly, business organizations are setup as going concerns and such an assumption of implied stagnancy in future operations or scale goes against the basic principles of business;
Finally, while real goods are subject to the forces of demand and the manipulation of the supply by firms, a business organization is setup to consistently experience growth as demand increases by diversifying and expanding its product quality and quantity in other to meet perceived growing demand. The basic assumptions of market equilibrium are based on the fundamental believe that investors are rational. This is flawed mainly because the varying risk preferences, returns expectation, the manner in which information from the market is interpreted, and the disreputable practices like short selling results to market disequilibrium. Some analysts however point to the fact that naked shorting, albeit inadvertently, may help markets stay in balance by allowing the negative sentiment to be reflected in certain stocks' prices (Investopedia 2008), but that assumption is yet to be authenticated. A more in-depth explanation would be provided for this later on during this paper. Biology In considering the field of biology, the author believes that the mechanism of the economy and markets can be understood by considering the core theory of evolution. The theory was developed by Charles Robert Darwin November, 1859. The natural process of evolution – continues Hagstrom - is one of natural selection, seeing the market as an evolutionary framework allows us to observe the law of economic selection. According to Rockwood (2004), Darwin believed that natural selection could produce variations that had some benefit to a species and its survival. These variations, and their subsequent benefits to the species, would be passed on to succeeding generations. On the other hand the law of economic selection proposes flexibility in the adoption of a new strategy that
would offer more profit making opportunity for a business organization. To the regulators, the law of economic selection offers an avenue to introduce new regulations that would protect investors and strengthen the markets. In view of the current global financial crisis, most business organizations have been forced to make changes to their major policies and strategy in a bid to cut operations and minimize losses. The regulators on the other hand - in view of the crisis that has been blamed on the unethical sale of subprime mortgages – have introduced regulations to prevent the occurrence practices in the future; for instance, the Securities and Exchange Commission – at the peak of the crisis – had issued an emergency order to protect Investors against Naked Short Selling1; and also relaxed the conditions of the mark to market accounting system which requires that companies adjust the book value of their assets to its (the asset) market value at the period. I believe the theory of economic selection contradicts the fundamental assumption of the theory of equilibrium which proposed the forces of equilibrium would always act to ensure that the prices and intrinsic value of stock would always trade at equilibrium. The major flaw with this assumption is the assumed rationality of investors and market analysts. Peter Bernstein observed this anomaly in his analysis of dividend yield from 1954 to 2008; Investors in the old days, says Peter Bernstein, appear to have behaved more rationally than investors in the more sophisticated and theoretically aware era since 1954. Differing generations of investors appear to have differing views on how bonds and stocks should behave as the environment changes. In view of the law of economic selection, Brain Arthur (economist) proposed that contrary to the implied stability, the world was constantly changing, it was full of upheavals and
Naked Short Selling: is the practice of selling a stock short (selling an instrument not owned by a seller at the time of sale), without first borrowing the shares or ensuring that the shares can be borrowed as is done in a conventional short sale.
surprises, and it was constantly evolving. After further research by the group at the Santa Fe Institute (to expand on the Arthur’s observation), they concluded that;
What happens in an economy is a function of the interactions of a great numbers of individuals, with the action of each individual influenced by actions of a limited number of agents.
The economic system is controlled by the competition and coordination between the agents of the system.
The behavior, actions, strategies of the agents, and services consistently adapt to changes that result from new markets, institutions, behaviors and the likes.
The economy is in constant change, and operates far from equilibrium.
Hagstrom describes major changes in the system as a feedback loop. A feedback loop refers to the situation in which the agents form initial expectations or models and act on the basis of predictions generated by the model; but which constantly undergo changes as the new scenarios evolve and new conditions are introduced. As the models change, so does the predictability if the future occurrences. Arthur defines the economic system as complex, adaptive and evolutionary and as a result agents in the system compete for survival against the predictive models of other agents, and the feedback generated result to further changes to the models with other non performing models abandoned. For instance proponents of this main idea have propounded a new theory to the characteristics of market known as the adaptive market hypothesis. Adaptive Markets Hypothesis (AMH) , is based on some well-known principles of evolutionary biology (competition, mutation, reproduction, and natural selection), (Lo, 2004) ; I argue that the impact of these forces
on financial institutions and market participants determines the efficiency of markets and the waxing and waning of investment products, businesses, industries, and ultimately institutional and individual fortunes. I believe this theory proposing the evolution of models and economic structure is fundamentally acceptable. As economies grow and new infrastructure and technology is being introduced outdated or crude methods or ideas are abandoned. This fact was very evident in the manner in through United States Treasury department redefined the $ 700 billion dollars approved to bailout financial institutions during the current financial crisis. The treasury claimed the changes were due to modifications (economic selection) on the perceived impact of the bailout funds, and in the words of the interim assistant treasury secretary – Neel Kashkari “strategy evolved as conditions changed”. In summary to the impact of the theory of evolution, I believe that “a generation (or system) learns from the mistakes of a previous generation, only to give birth to a new generation that would make new mistakes to be learnt by a successive generation. Social Sciences In this field, Hagstrom defines the mechanism of the market based on the behavior of the participants in the market. The participants – usually consisting of financial analysts, investors -in the market, could be analyzed by groups in other to understand their group behavior. Most social scientists however oppose the relevance of a group analysis of the markets; for instance, the neoclassical school of thought assume transactions take place in a social vacuum whereby identities of buyers and sellers, as well as prior history of transactions or social relations, are largely irrelevant. Markets are by and large seen as “unstructured aggregations of individuals, the ‘buyers’ and ‘sellers’ coming together for only short-lived dyadic exchanges.” (Khan Pyo Lee,
2004). However, there exists no market without exchange and no exchange without interaction. The social interaction is the necessary condition to the building and the spatio-temporal organization of a financial market (Schinckus, 2004). According to Hagstrom, Social scientists adopt the scientific approach as they work to explain how human beings form collectives, organize themselves and interact, and based on their findings they develop theories that led to the construction of models that can be used to properly analyze given data. This approach, however, is flawed on the basis of the unpredictable behavior of human beings, which is a factor that negatively affects the authenticity of results generated. I believe that every line of conversation (on ideas and convictions) leverages on the scientific method. One of the major problems encountered in observation and personal expression, is that people make a lot of assumptions (hypothesis) based on a limited number of observations, and deduce faulty conclusions from these untested assumptions. The impact of economics as a discipline in the social sciences cannot be over emphasized. It is a field of study that examines how society manages its scarce resources. Economists therefore try to determine how people make decisions, based on their salary, their buying and saving habits, and how they allocate their savings. Economists also study how buyers and sellers of particular goods forecasts the price a good will sell at and what quantities of the goods will sell at the agreed-upon price. Finally economists analyze issues that affect the economy as a whole (Rockwood, 2004). Hagstrom portrays economics as the first discipline to attain a status of separate study in social science as a result of the early work of Adam Smith - also known as the founder of economics - on the Wealth of Nations. He is popular for his advocacy of the laissez- faire capitalist system that discourages government interference in the economy. However, in the wake
of the current global financial crisis such theories have been dismissed as being too risky and unrealistic; for instance, the government failed to intervene in rescuing the distressed Lehman brothers Inc, in which the US Treasury eventually admitted it had taken an extremely gutsy gamble by letting Lehman fail; mainly because of its subsequent impact on global financial markets with record breaking job losses and 2-4 percent loss in the value of the stock exchanges in United States, Europe and Asia (New York ,AFP, 2008). Bernstein argues that when financial markets experience a significant disruption, a systematic approach to risk management requires policymakers to be preemptive in responding to the macroeconomic implications of incoming financial market information, and decisive actions may be required to reduce the likelihood of an adverse feedback loop. Hagstrom argues that the theory of division of labor had negative social consequences on the economy which includes a decline of general skills and craftsmanship, perceived incorporation of women and children into workforce, and the tendency to divide society into economic classes and opposing interests. I believe these assumptions a partially flawed on the following grounds; firstly, division of labor promotes efficiency, reduces labor time as a result of efficiency, develops team spirit of social service, discourages selfishness, fosters easy organization of work groups and social clubs, and increases time for leisure and social intercourse (Thompson, 1923). He portrays political science as a focus on the behavior and impact of government on the society and how they are created by the people; anthropology which was concerned with the evolution of man as a species (physical anthropology) and the investigation of the social aspects
of the many different human institutions found both the primitive and contemporary societies (cultural anthropology). Cultural anthropology gave birth to sociology2. Hagstrom argues that the market just like nature is in a constant struggle for scarce resources, and that the process of natural selection in humans would inevitably lead to social, political and moral progress. I believe this assumption is completely accurate because it assumes that human beings have a tendency of irrationality; the current financial crisis is an evident result of this fact. Bernstein (2008) correctly states that Human nature develops odd biases. According to him, the fundamental stability and growth momentum of the global economic system created a bulging appetite for risk taking that led investors around the world to gorge on anything that looked risky. A point came when any trigger would justify ever greater risk taking. According to Hagstrom, economies and stock markets are adaptive systems implying their behavior changes as individuals’ constantly interact with one another and with the system itself. An attribute that is peculiar to these adaptive systems is their formation process; which refers to how people come together to form complex systems and further organize themselves into some order. The economist Paul Krugman calls this the theory of self organization which stipulates that the evolution of cities is a self organizing and self reinforcing system. Hagstrom, however, draws a relation of this phenomenon to the transformation and adjustment of the economy mainly as a result of exogenous events (risks) such as oil shocks or military conflicts. I believe this assumption is not completely accurate because endogenous risk than they are exogenous risk. Endogenous risk (or events) refers to the risk of shocks that are generated and amplified within a system; exogenous risk on the other hand refers to shocks that arrive from outside a system. According to Danielsson & Song Shin (2002), financial markets are subject to
Wiki: Sociology is the scientific study of human behavior.
both types of risk. However, the greatest damage is done from risk of the endogenous kind; this was very evident in the stock market crash of 1987, the Long Term Capital Management crisis of 1998, and the collapse of the dollar against the yen in October 1998. These were all caused by endogenous risks, and they had more impact on the economy than oil price instability experienced during the third quarter of 2008. He further argues that economic cycles are caused by self reinforcing effects which led to greater construction and manufacturing until investment declines. He purports that such a decline in investment will subsequently lead to a decline in production which would in turn result to an increase in investment. What Hagstrom fails to understand however is that when production declines businesses could liquidate as a result of their inability to meet debt obligations. Hagstrom further elaborates on other characteristics of complex adaptive systems which include the theory of emergent behavior and states that as everyone in a system attempts to satisfy their needs they ultimately create an emergent structure in the system. He also explores the theory of criticality – by Per Bak – which states that complex systems composed of millions of interacting parts could break down not only because of a single catastrophic event but because of a chain reaction of smaller events which lead ultimately to a large catastrophe. Hagstrom advocates the theory of collective choice which stipulates that when all the agents in a system aggregate information in a way that allows everyone in the system to reach a collective decision such a decision would result to a stable outcome in the system. This is what Diana Richards chooses to call “mutual knowledge”. I however disagree with this view because in certain scenarios like the subprime crisis where most business executives where oblivious of the consequences of their actions, and as a result caught in a crisis that have collectively affected
the financial system. As a result of this, I believe it would not be inappropriate to say that in some conditions mutual knowledge could actually be disguised mutual ignorance. This is reinforced by Gustave Le bon in the next chapter. Psychology Psychology is the science that studies the workings of the human mind. Its main focus is to study of the workings of the brain, mostly the parts that deal with cognition and emotion. The importance of understanding the workings of the brain cannot be overemphasized, studies have shown that by comparing the amount of blood flow to different parts of the brain before, during, and after the task, it is possible to detect higher levels of activation in certain regions of the brain, thus associating the performance of the task with those regions (Andrew Lo, 2005). Hagstrom explains that through psychology we can understand how stakeholders to the financial markets think, communicate, experience emotions, process information, and make investment decisions; through psychology analysts are able to predict the response of investors to a new regulation, investors (through the help of financial analysts) can understand the temperament of a company through its financial statements and the prospective options, fund managers are able to make credible forecasts that guarantee higher returns for their portfolio etc. Hagstrom focuses on the impact of the cognitive and emotions domains of psychology on the quality of decisions and direction of the market. This concurs with the opinion of Benjamin Graham – a successful investor, teacher, writer and industry leader – who implies that the problem experienced in the market is really as a result poor interpretation of available data from information (processed data). In his words, Graham states that “the problem of the industry is speculation per se; speculation has always been a part of the market and always will be”. He
further states that our failure as professionals is the continued inability to distinguish between investment and speculation. I believe this opinion is accurate; in the financial markets today there has been an overdependence on models to interpret and predict the direction of the market, with so much models created as an aid to speculation, a majority of the analysts today depend on these models without an attempt to question the authenticity of the data they provide. Hagstrom, in his opinion, believes that investment decisions based on emotions usually tend to be faulty because they are irrational. Irrationality in this context referring to decisions that are based solely on returns irrespective of the risk involved. These types of investors base their investments decisions on gut feeling and gambles, instead of on a careful analysis of the opportunity. The author also illustrates the effect of a group on individual judgment by adopting the theory of Gustave Le bon (a French sociologist). Le bon observed that in a group individuals who may be very different from one another in every respect, are transformed into a unified body with a collective mind that causes members to behave very differently than they would if each person were acting in isolation. The sociologist observed that the opinion of the group causes people to sacrifice their individual views. I prefer to refer to this as the “crowd effect syndrome” which is really a major cause of the pending global financial crisis; most investment banks took part the subprime mortgage investments knowing full well the risk involved, but they took this for granted on the guise that since every other investment bank and financial institution was involved they could get away with it. Philosophy
Philosophy is the study of the nature of existence, knowledge, truth, beauty, justice, validity, mind, and language. According to Quinton (1995), it is "thinking about thinking. He elaborates further by defining philosophy as rationally critical thinking, of a more or less systematic kind about the general nature of the world (metaphysics or theory of existence), the justification of belief (epistemology or theory of knowledge), and the conduct of life (ethics or theory of value). Hagstrom revisits the issue of the market as a complex adaptive system. Lee Mcintyre a professor of philosophy – carried a study on the complexity theory, and came up with the following conclusion; firstly, complexity thrives on the fact that we do not have complete knowledge on some systems, which makes complexity in-eliminable as a result the incapacity to understand them fully. Secondly, he states that complex systems are not inherently complex but rather appear so only because of our limited descriptive capacities. However, Mcintyre believes that the sense of disorder that is a function of the complexity can be eliminated if the system can be reanalyzed and re-described. I believe this approach would seem appropriate, but it would cost even more to offer new explanations about the workings of the market in its complexity, in a hope to do away with its previous accepted principles. Pragmatism is the aspect of philosophy that defines the truth in statements and rightness based on their practical outcomes. Pragmatism according to Hagstrom focuses on open minds, and gleefully invites experimentation. It rejects rigidity and dogma and welcomes new ideas. Pragmatism is – from my view – a very important attribute to investing. This is partly because it eliminates principles and ideas that are not practical and adopts those that offer prospective returns with a past record to prove it. The major flaw is that there is a risk of rejecting new untested ideas that could offer higher returns on the guise that they do not have a past record of
viability. However, a pragmatist is very conscious of the continued viability of an adopted model, strategy etc Bill Miller – a very successful portfolio manager – states that models have tendency to work for a while and then stop working. In such a situation, fund managers are expected to adopt newer models and discontinue ineffective ones. Kurtay (2004) elaborates on this by stating that “the impact of changing economic conditions as well as the introduction of new asset categories on modeling assumptions needs to be monitored continuously, and appropriate methodologies and techniques should be implemented in response to these developments to keep the asset allocation as efficient and prudent as possible. In investing on the markets the portfolio managers have faced two prospective models of investing: the first-order model focuses on the William dividend discount model that is structured to meet the criteria for value investment because it determines the real value of securities; the second-order model however focuses on other measure like low price earnings ratios, low priceto-book ratio and the likes. The success experienced by Bill Miller as one of the most successful fund managers is attributable to the fact that he quickly recognized the difference between first order and second order models; he had broader approach to sourcing for information on securities that transcended the field of finance and economics. According to Bill Miller "I often remind our analysts that 100% of the information you have about a company represents the past, and 100% of a stock's valuation depends on the future."
Literature The author in the last chapter of the book provides an avenue through which the average student, investor or analyst can effectively carryout the art of reading. He presents the approach to reading in stages with motives that are outlined in form of questions, which are as follows: i. What is the book about as a whole?
ii. What is being said in detail? iii. Is the book true, in whole or part? iv. What of it? While this is important for effective reading, he proposes different types of reading that vary with the purpose intended. These include; Elementary reading which is achieved in elementary education; Inspectional reading, is the form of reading which mainly involves scanning through the book in other to determine if you are interested in reading the book further; Analytical reading, involves thoroughly going through the book with the intention of absorbing the content of the book. PAPER 2: PHYSICS – PRINCIPLE OF EQUILIBRIUM Physics is an advanced form of natural science that seeks to understand very basic concepts such as force, energy, mass, and charge (Holzner, 2006). More completely, it is the general analysis of nature, conducted in order to understand how the world around us and, more broadly, the universe behaves. Physics as a field of study has always proved to be very relevant to the field of finance because of its basic concepts and principles that have helped in fostering a
sense of certainty and – in Hagstrom words – given us the comfort of absolute answers. These concepts and principles are One of the principles that have played such a major role is the law of equilibrium propounded by Sir Isaac Newton. Newton’s Law for equilibrium is divided into two forms namely: static equilibrium and dynamic equilibrium. The law for static equilibrium states that an object at rest will remain at rest, while an object moving at a constant velocity will continue to move in that fashion until it is acted upon by an unbalanced, outside force; while the law of dynamic equilibrium states that the acceleration an object experiences is directly proportional to, and in the same direction as, the net force acting upon it and is inversely proportional to the object's mass (C. E. Linebarger, Silas
Ellsworth Coleman 1911).
These laws distinct but similar in purpose both have significant roles in some of the basic principles applied in economics and finance. Economics, says Hagstrom – have turned to the Newtonian paradigm and the laws of physics. This has led to the development of a field simply known as Econophysics. Econophysics - as stated earlier – is the Econophysics –is an approach to quantitative economy using ideas, models, conceptual and computational methods of statistical physics (Jurkiewicz & Nowak, 2003). Econophysics became a regular discipline covering a large spectrum of problems of modern economy; and one of such problems is in the area of eliminating market anomaly and fostering its stability. The equilibrium theory of Isaac Newton infers attaining market equilibrium through the interplay of market forces; for example as with static equilibrium, it emphasizes the effect of the forces of demand and supply that must collectively function to ensure the market attains stability
by remaining in equilibrium. Alfred Marshal – a pioneer economist – concurs to this view by arguing that “when demand and supply are in stable equilibrium, any factor that changes or alters that state of equilibrium would be met by an opposing factor working to restore the previous state of equilibrium. The efficient market theory – according to Rockwood (2004) - is an example of such thinking, since it states that stock prices and their intrinsic values always trade in equilibrium in the market. Andrew W. Lo (2005) further explains that the theory was established on the notion that markets fully, accurately, and instantaneously incorporate all available information into market prices. The advocates to this theory believe the market is composed of rational investors that possess all the information they need, and can equally interpret such information efficiently. Louis Bachelier stated that the market, the aggregate speculators, at a given instant can believe in neither a market rise nor market fall since for each quoted price, their existed as many buyers as their sellers; which ultimately meant that the market would always be stable since the forces of demand and supply were uniform. Samuelson – a Nobel Laurent – reinforced this theory by stating that the market was made up of people who were rational thinkers, hence the stock prices at any given point in time were a reflection of rational decisions. To further strengthen the resolution of these advocates of financial market equilibrium, Eugene Fama – in his doctoral dissertation – asserts that “in the efficient market, a great many smart people ( Fama called them “rational profit maximizers”) have simultaneous access to all relevant information, and they aggressively apply that information in a way that causes prices to adjust instantaneously – thus restoring equilibrium – thus restoring equilibrium before anyone can profit. Verdict
I believe the syllogism - of these economists – is not accurate because the premise of their opinion is faulty. Firstly, these economists supporting the efficient market theory – which advocates market equilibrium -assume that the market is made up of rational investors. According to Ariely – Professor of business – “Humans aren’t the perfectly rational beings that classical economics assumes them to be. No, they’re slyly deceitful and self-contradictory, subject to subtle forms of mind control. In a study, he once put 6-packs of Coke or plates with six one-dollar bills into shared refrigerators in college dorms to see if cash itself was a variable in people’s honesty. The cash was untouched for 72 hours; the Cokes were all lifted. He also found that simply substituting a token for cash — even a poker chip that will quickly be converted to cash — encourages more cheating (Leif Bates, 2008). Studies have shown human decision making does not seem to conform to rationality and market efficiency but exhibits certain behavioral biases that are clearly counterproductive from the financial perspective Andrew W. Lo (2005). Agents of the market have varying preferences, reaction to information, and strategy to investing; while a category focus on the short term benefits to investing, others are concerned with long term expected returns, and while some appear to be highly risk averse, others appear to be risk takers. Some of the events in the markets that portray the erratic behavior of investors – according to Alan Greenspan – include the 1634 to 1636, “tulip mania” spread through Holland, causing the price of tulip bulbs to skyrocket to ridiculous levels, only to plummet precipitously afterward, creating widespread panic and enormous financial dislocation in its wake. Other examples include England’s South Sea Bubble of 1720, the U.S. stock market crashes of October 1929 and October 1987, the Japanese realestate bubble of the 1990s, the U.S. technology bubble of 2000, the collapse of Long-Term
Capital Management and other fixed-income relative value hedge funds in 1998, the real-estate bubble in England and the current global financial crisis. The theory of efficient markets also assumes that the agents in the market have simultaneous access to relevant information. This position eliminates the possibility of making abnormal earnings from information received; but this is not the case with current trend of prosecution as a result of insider trading violations. According to Hagstrom Bill Miller – a renowned fund manger- infers that the information from the market in itself is not sufficient to base an investment decision; which further puts a doubt to the quality of the information in the market. In equilibrium – according to William Sharpe – the capital asset prices have adjusted so that the investor, if he follows rational procedures (primary diversification), is able to attain any desired point along the capital market line. He may obtain a higher expected return by incurring additional risk (Sharpe, 1964). However, Dr Sharpe in an early article decried the total validity of this assumption, because –in his words – “any could game this” implying that the model could be manipulated by fund managers to appear favorable. This really is as result of the complex nature of the market which is not totally stable - mostly in recent times. I believe the principle of equilibrium is very practical but would have a more favorable impact on commodity markets than it would on the security market characterized by agents that hope to take advantage of the system to generate returns.
References Andrew W. Lo, Ph.D (2005) Reconciling Efficient Markets With Behavioral Finance: The Adaptive Market Hypothesis, VOL. 7, NO. 2, Anthony Quinton, (1995) "Philosophy," in T. Honderich (ed.), The Oxford Companion to Philosophy (Oxford University Press,), p. 666: C. E. Linebarger, Silas Ellsworth Coleman (1911). A Text-book of Physics. Boston MA: DC Heath. p.p. 128, Charles Manfred Thompson (1923) Elementary Economics" Benj H Sanborn & Co Christophe Schinckus (2004) Sociology and Semiotics of Financial Markets. CEREC - Facultés St-Louis – Brussels GRESE – University of Paris I Panthéon – Sorbonne Encarta ® World English Dictionary © & (P) 1998-2005 Microsoft Corporation. All rights reserved. Steve Holzner, Physics for Dummies (2006), Wiley. Chapter 1, page 7 says: "Physics is the study of your world and the world and universe around you." See Amazon Online Reader: Physics For Dummies (For Dummies(Math & Science)), retrieved 24 Nov 2006 Jon Danielsson & Hyun Song Shin (2002) Endogenous Risk London School of Economics Khan Pyo Lee (2008) Social Organization of Markets in China’s Transformational Economy: The Case of the Auto Components Sourcing Network, Peking University. Karl Leif Bates (2008), Predictably Irrational, but Highly Entertaining: Ingenious Tests of Human Nature Mix Jane Goodall and B.F. Skinner. L. Montes (2003). Smith and Newton: some methodological issues concerning general economic equilibrium theory. Cambridge Journal of Economics, 27(5), 723-747. Peter Bernstein (2008) Two Little-Noted Features Of The Markets And The Economy.
Peter L. Bernstein (2008), The Shape Of The Future. Redman, Deborah. & A., Scottish (1993). Adam Smith and Isaac Newton. Journal of Political Economy, 00369292, May, 2 (40) William F. Sharpe (1964), Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. The Journal of Finance, Vol. 19, No. 3, pp. 425-442 Z. Burda, & J. Jurkiewicz & M.A. Nowak (2004) Is Econophysics a Solid Science? Institute of Physics, Jagellonian University, Poland. http://landscaping.about.com/cs/lazylandscaping/g/latticework.htm. Latticework David Beaulieu, About.com retrieved Nov 29, 2008 http://business.maktoob.com/NewsDetails-20070423185119Lehman_Brothers_fails_plunging_world_economy_into_danger.htm Lehman Brothers fails, plunging world economy into danger (afp) Sep 2008. http://www.sec.gov/news/press/2008/2008-143.htm: SEC Enhances Investor Protections Against Naked Short Selling http://www.sec.gov/spotlight/fairvalue.htm: Fair Value Accounting Standards http://www.nationmaster.com/encyclopedia. Latticework, National Master Encyclopedia Retrieved on 2007-02-27. http://www.c-span.org/Watch/watch.aspx?MediaId=HP-A-10986 HOUSE OVERSIGHT SUBCMTE. HEARING ON FORECLOSURE PREVENTION Friday, November 14, 2008
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