The Chinese Stock Market

In late 2007, the Shanghai stock market was going through a boom. A Professor of Economics was visiting China and there he learnt that everyone, everyone was expecting the stock market to crash after the Olympics in September 2008. In other words, they assumed the market to keep rising like a Diwali rocket till then, and then fall dramatically.

The professor was amused that no one had reasoned backwards from there. Everyone expected the market to fall in September. So, what would happen in August? Wouldn’t they think, “Hey, I don’t want to get too greedy. I know that the index will rise another month, but what if it suddenly starts falling  and I am caught short? I had better sell right now and book my profits.”

Now, if many people think so, prices will fall, not in September, but in August. But if everyone knows that everyone else is thinking that way, why would they wait till August? Won’t they start selling in July? And so on, by induction, if people expect the market to tank in September, prices should fall right now.

This is what traditional economics suggests. Behavioural economics argues that the professor’s analysis is incomplete. Obviously, not everyone will decide to sell in August, but some people will. What will happen in the market is the classic battle between greed and fear. Some people, overcome by greed, will hold on in the hope of making even more gains, while some people, overcome with fear, will sell. At some point, fear will overcome greed and the market will crash.

So, behavioural economics is useful. It helps us understand why booms and busts occur. But is it useful in the sense that we can do something about it? One way of doing something about it is to profit from our knowledge of behavioural economics. If I can use this new science to predict exactly (or even approximately) when the boom will turn into a bust, I can keep buying just before that point and then sell. If I can do that, then I can make consistent supranormal profits, and the Efficient   Markets Hypothesis would have broken down. Of course, I will also need to keep my knowledge and actions secret from others, because if everyone starts doing what I did, then my knowledge will be useless.

So, when Ritwik says that behavioural economics will falsify the EMH, this is what he means (or should mean). But is it anywhere close to doing so? While it is good at explaining, in terms of actually predicting, it is no better than a trader’s gut feel. This is not surprising. Even after the  behavioural scientists have a working theoretical model of a human society (which I doubt they have yet)  they will need to come up with the data that they can feed into their models.  This data is inevitably voluminous and difficult to obtain.

So, instead of asking me whether scientific models have to be perfect to be used,  Ritwik needs to explain what stage of usefulness his preferred models are at.  Right now, we have some theories that have been validated by surveys of actual human behaviour, and through experiments performed in controlled laboratory settings. Occasionally, we have seen them validated in pilot studies, but even here, conditions are fairly controlled.  What we need to see is a working model of human and social behaviour that puts together most of the theories that we have come up with.

In other words, what we have right now is equivalent to a situation where Newtonian laws of Physics are being developed, and it is being claimed that developing complex machines is a trivial step that can be left as an exercise to the reader. Yeah right. Someone just has to put together Newtonian mechanics, corrections to them that need to be performed when you apply coefficients of friction and air resistance, the laws of electromagnetism that will come into play when electricity is involved, and then predict how the machine will behave in real life. None of these will require Einstein-like genius, but it does require a lot of work. Engineers these days can put together a machine entirely on computer and be able to predict very well how it will behave, but it has taken a couple of centuries of trial and error to get to that stage. It takes astonishing hubris to claim that we have reached that stage with a science that has developed in the past 3 decades and which deals with systems as complex as the human mind and human society.

9 thoughts on “The Chinese Stock Market”

  1. Dude you should have just linked to your post explaining why psychohistory won’t work. Other than that good post. Though I have no idea how did the discussion turned from global warming to EMH

  2. Inference by induction was repudiated for science itself by Karl Popper. There is no “perfect” scientific model, a model is true only insofar as it has “not been falsified yet”.

    You are right in the parallel to science, as finance was also proceeding by induction/observation so far, and only now, there are many thinkers of the Popper kind in finance – Soros, Taleb and Kahnemann/Tversky in finance, who are saying that if Popper’s falsification is suitable to science, it is so much more valid in the social sciences. There are no “perfect” financial models, most of them break down every now and then.

    Good conclusion, but why such verbose, ritwik like reasoning to get to it? If I were your editor, I will keep your last para and delete everything above it.

  3. Because you are neither my editor nor my intended reader. I am my editor, and Gaurav, who is smart but doesn’t know much about economics or finance, is my intended reader.

  4. Incidentally, I did a BTech in Mech Engineering, and I did have a prof who believed that actual engineering was a trivial exercise. His exact words were: “You don’t learn anything *new* after the second year.” Now, this being IIT, we were taught a lot of theory till the second year and moved to hardcore engineering only in the third year..

  5. Ravikiran,

    I wasn’t actually claiming that we have reached ‘that’ stage. I was just saying that we have this one new way – let’s make it one of our ways in precisely the kind of trial and error that you refer to. I understood your position as ‘given that there isn’t a robust prediction model yet, let’s not embark upon anything suggested by this model’, and my position was simply a counter to that, in much the same vein as this post of yours.

    Someday, when I understand really how useful for prediction my prefered models (as you choose to call them) are, I will be framing policy instead of writing and commenting on blogs. Till then, I will just link to my intellectual superiors.

    Other than that, I agree with pretty much what you have to say.

    Avataram,

    Rev. Thomas Bayes makes Popper seem like a fool. Popper’s views on the philosophy of science, or more precisely, a restrictive interpretation of Popper’s philosophy of science says something that is laughably trivial to a sophisticated mind.

    And his free society followers, Soros and Taleb, in their literary pursuits, indulge in the kind of nihilism that does no one any good. It doesn’t help that neither is a very good writer. Thaler, Kahneman/Tversky and Shiller/Akerlof are the ones to really turn to, for they are engaging in construction from the same basic views and data that Soros/Taleb endorse.

  6. Since Ritwik does not seem to be around, let me argue for him.

    If Ritwik now says that the Popper like reasoning in finance – that most financial models are wrong – comes from Behavioral economics – that Kahnemann/Tversky, Taleb, Soros can be classified as Behavioral economists of a kind, will you still insist that they supply you an inductive proof in terms of Supranormal profits? (Soros has done that, BTW).

    These people may not be claiming anything like a working model of human behaviour. Some of them are now saying such neither standard economic models nor models of behaviour can exist. Does it make sense to demand some kind of proof from them, or ask them what stage of development their theories have reached?

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