Why financial markets are deceiving prophets

April 19, 1720 the famous British scientist Sir Isaac Newton ordered his attorney to sell his shares of the Company of the South Seas - founded in 1711, the enterprise has a monopoly on trade in the South American colonies of Spain. Newton was rescued by three thousand pounds. It was a successful closing of a position: to trade in the years 1718-1719 in the area just above the £ 100 shares at the beginning of 1720 became wildly popular and reached the mark at 350 pounds by April. However, growth has continued, and the action to overcome the bar to 1,000 pounds. Many friends of Newton, not rushed to the sale of shares, rich, and a great scholar decided to "reconnect", but with a serious amount. The result was disastrous - the speculative bubble burst (as always, suddenly), at the end of September 1720, the Company's share of the cost of the South Seas had fallen to 150 pounds. According to the accounts of contemporaries, Newton did not like to remember about his failure, though, according to his niece, the losses were considerable genius - 20 thousand pounds ($ 6 million in today's money). Only one of comment about the scientist failed speculation: "I can calculate the motion of stars in the sky, but to calculate the human madness I can not." Newton's phrase may well replace him thousands of books on investing. The latter occurred before our eyes the collapse of the American market for mortgage bonds - it is a typical episode of euphoric boom and the subsequent collapse. There is nothing unique - in the economic history there have been hundreds of such cases, the differences only in scale. The history of bubbles. The first well-studied by economists financial bubble is dated 1636-1637 years (tyulpanomaniya in Holland), and the first global financial crisis - 1825 (the acquisition of Latin American independence, which caused the flow of capital into the then emerging markets, re-evaluate their assets and the subsequent fall, which had a global impact .) Since then, the world has seen several global boom and bust. In 1873 the collapse of the real estate market in Germany has led to global shocks (such as fallen stock of railway companies in the U.S.). In 1890, the crisis erupted Baring: one of the largest banks in the London of that time Baring Brothers overestimated the prospects for emerging markets - Argentina, Uruguay and Brazil - and went bankrupt. Effects, except for the Old World feel the United States, Japan and Australia. In 1907, the panic in the U.S. stock market has touched France, Italy, Japan, Denmark and Sweden. In 1929, the U.S. and later in other countries had grown to burst 1920s bubble in the stock market. Subsequent bank panic and a number of errors on the part of regulators have grown into a worldwide Great Depression, the consequences of which were completely resolved only after the Second World War (the question of what the Great Depression and partly caused the war, still remains a subject of scientific research). The postwar period was relatively quiet. A serious crisis occurred only in 1982: the debt crisis in Latin America (Mexico, Argentina, Chile and Ecuador) caused problems for banks around the world - the U.S., for example, had to save Chase Manhattan and Citicorp. The second half of 1990 marked a string of crises - in 1997, an asset bubble deflated in Thailand, Indonesia and Korea, in 1998, falling demand for commodities from Asia auknulos the Russian debt default and serious problems in Brazil. Russian crisis and hurt the United States. This list is not complete and does not include various local financial bubbles, such as savings and loan crisis of institutions in the 1980s and the dotcom crash in the early 2000s in the United States. Blind to the models. The financial euphoria, bubbles and deflation, accompanied by economic crises, as we see, quite ordinary and quite frequent. But why, despite all the advances of economic science, economists have not learned not to prevent or anticipate financial disasters? Why all these crises occur? The answer to this question would have been invaluable. Expert to explain the nature of bubbles are plentiful. Blame and cheap money (low interest rates and easy credit), and a lack of control over monetary policy by regulators, and the greed and manipulation by financial speculators (banks, hedge funds, etc.). Generally, this transfer can be quite lengthy, but this is only indirect causes. The fundamental reason is much deeper, it is rooted in human nature itself. Almost the entire second half of the twentieth century, the generally accepted among economists considered the "efficient markets hypothesis" 1 (Efficient market hypothesis, EMH). As you know, the idea was that economic agents have to increase their own welfare (maximization of utility function), are completely rational, have access to all available information. This assumption has allowed economists to model the rational behavior to elegant mathematical formulas. These emotions are all familiar, like pride, envy, fear, greed, doubt, as well as the asymmetry in access to information and the ability to appreciate it, were left behind simply because they are almost impossible to take into account in the elegant models. However, the behavior of actual homo sapiens is far from all-knowing and cool rationality model homo economicus, man is limited in the perception and, moreover, in the evaluation of information is human nature to make big mistakes in logical and probabilistic reasoning, especially in areas where the interaction of many conflicting factors. Here is an example. During the mortgage boom in the U.S., even math geniuses on Wall Street were not able to evaluate all available information. Thus, it is estimated the executive director of the Bank of England Financial Stability Andrew Holdeyna2, before buying a standard CDO (Collateralized Debt Obligation) investors would have to examine 30 300 pages of information for a more complete understanding of what they actually buy. The information content of more complex derivatives, such as CDO-squared, reached one billion pages. Of course, no one has been able to absorb such an amount, and the actions of investors amounted to a mere following of credit ratings assigned to securities by rating agencies. Once in the midst of crisis, rating agencies, sumnyashesya negligible, a few steps together to lower their ratings of CDO, it became clear that the evaluation of these offices is as superficial. The blind leading the blind, both well-known painting by Brueghel. In addition, it is important to understand that the market often ruled by the rare (or random) events ("black swan" Nassim Taleb, in the terminology), information to accurately calculate the probability of which may be missed or did not exist at all. "This is a lucrative market like sleeping on railroad tracks. At some point, an unexpected train will move you. You make money every month for a long time, then lose a big part of your gross income for a few hours "3. Thus, analysis of mass media and the construction of complex mathematical models have not helped the winners of the Nobel Prize in Economics, Robert Merton and Myron Scholes. After several very successful years in 1998, their hedge fund Long-Term Capital Management went bankrupt in just a month (the fund has destroyed the volatility in the market after the default of Russia). Meanwhile, according to the developed mathematical geniuses LTCM risk assessment model Value at Risk, it was assumed that the losses incurred by LTCM later in August 1998 will be an event so improbable that it is unlikely to happen for the entire age of existence Vselennoy4. At the beginning of the mortgage crisis in August 2007, CFO Goldman Sachs, David Viniar said in an interview with Financial Times: «What we see now - the event with a probability of 25 standard deviations for a few days to a number." 25 sigma probability - a 1 to 61 012 Vselennoy4 our ages. As you can see, the market likes surprises than built into the elegant models - no one unforeseen events occur on it with enviable regularity. Why? "Because all models are wrong, the only model that is not false, it is a reality, but it is by definition not a model" 5, explains Haldane. Laugh and whole world will laugh with you, cry and you will cry alone. Difficulties, however, arise not only with information processing and evaluation of the probability of rare and random events, but also the emotions. Researchers behavioral ekonomiki6 (in contrast to mainstream economics, this trend closely examines the psychological aspects of the economy) indicate that a major factor in shaping the financial bubble of false supply estimates are overly optimistic and "positive narratives of" success stories that people tell each other. Just as the spread of disease due to infection, as well formed, and the market euphoria. Media, magazines and books picked up by a wave of public enthusiasm - the success stories are interesting and the story-teller and the listener, this is characteristic of human psychology, of not less frequent stories of failures molchat7 prefer, remember Newton. During the boom in the 1920 U.S. women's magazines were full of stories of successful investments and urged the young lady did not miss his chance in the stock market. And not just maids, taxi drivers, waiters and cleaners of footwear under the influence of success stories. One of the founders of modern economics, John Maynard Keynes, a few days before the collapse in 1929, said he sees the prospect of further growth in stock prices for several months. He also lost a lot of money (hello to you, Newton!). Distribution of narratives of success clearly shows the dependence of the specific individual opinions on the opinion of the group. If you follow the FER, market prices are always correct, since they reflect independent assessments of investors. Even if some investors are behaving irrationally rational investors in this case have the opportunity for arbitrage, which corrects a result of the possible failure outcomes. So? No, not so. Indeed, there is evidence that, subject to independent evaluation of aggregate collective opinion is more accurate than individual estimates. Empirical illustration of this phenomenon may be an "experiment Trainor" 8. 56 participants of the experiment carried individual estimates of the number of balls in a jar (there were 850). The aggregate score was $ 871 ball, and only one participant out of 56 gave a more accurate estimate than the group as a whole. Many other studies replicated in different ways and this experiment showed that a generalized opinion groups tend to be more accurate than individual estimates. Probably the reason why individuals are so often used in their assessments to help "collective intelligence". It would seem that nothing beautiful confirmation of ERT? The invisible hand of the market itself is a collective corrects all errors of individual choice! However, not all that easy. The history of bubbles and financial crises shows us that the crowd often goes in the wrong direction. The reason for the failure of the collective mind is that the markets there is no aggregation of independent evaluations, and the so-called informational cascade - a situation where a choice is made depending on the observation of a choice made earlier by others. In terms of information cascades individual assessment of losing independence and therefore is distorted. In some cases, this distortion can be up to the absurd, it is recalling the dynamics of the formation of a market bubble. Article economist Abhidzhita Banerjee, "A simple model of herd behavior" 9, we find an example of such distortion. Assume that each individual has some particular opinion on some issue (this is an approximate opinion, he was not sure it 100 percent correct). However, he monitors the actions of others, and information obtained through this monitoring is for him a high enough value and can change its initial shaky proposition. For example, in the same city 100 people trying to choose which restaurant to go - either A or B? Everyone has their opinions on this matter: for example, 99 people believe that restaurant B is slightly better. But anyone who thinks that the best restaurant A chooses first. Monitor and evaluate the previous second choice an individual can also choose to restaurant A. The third is even more likely to be in A, and the fourth, fifth, and so on. As a result, a restaurant would be packed, and the restaurant B is empty, although initially 99% of people felt that the restaurant B is better. This is absolutely irrational and paradoxical result is possible in the markets of many assets, because they also represent a variant of information cascades all looking at each other, or may buy shares at home, although individual confidence in the correctness of this action can not be so very great. Together cheerfully to walk. But maybe all these irrational markets make analysts and economists to be more cautious in their assessments? This is not the case. As practice shows, market professionals en masse no less optimistic and irrational than the crowd. Thus, the study McKinsey10 shows that over the past 25 years, analysts' forecasts for companies in the U.S. the S & P 500, have been steadily sverhoptimistichny, their average forecast profit growth stood at 12% per year, whereas in reality, the growth was 6% . A brief study of the "AF" shows that Russian intelligence is not very often right. A more sober heads, occasionally occurring among economists and even less - of the market "professionals" to indicate general euphoria of the risks and the possibility of a collapse, as a rule, ignored or ostracized as alarmists, and whiners. Thus, in 2006 professor of economics at New York University's Nouriel Roubini declared overvalued U.S. real estate. Investors and buyers of houses immediately nicknamed him Dr. Death (Doom), laughed and continued to listen, for example, the head of the U.S. Federal Reserve Chairman Ben Bernanke, who in the same year, said among other things, that "the growth in property values ​​largely reflects the strong fundamentals of the economy" . This is another illustration of the irrationality of human behavior: people tend to derive from the flow of information, only the information or opinions that confirm the previously adopted their point of view, and ignore or underestimate the information that contradicts it (confirmation bias, or "ostrich effect") . Explanation of excessive optimism of market analysts and economists is not only a collective irrationality but in the peculiarities of motivation of this professional group. "The world is headed career risk analysts - said the manager of one of the largest American investment funds GMO Jeremy Grantham. - Behavior of each imperative is to keep their own positions. You have to understand how to keep your job: never, ever be wrong alone. You can be in a puddle in the company of others, this is normal. For example, all the CEO, say, the 30 largest financial companies have not noticed approaching collapse of the mortgage bubble in the U.S., none of them saw the looming crisis inevitable. And, of course, they are all now in unison shouting: "No one saw him approaching!" Although, of course, such seers were, but they occupy a marginal place in the world of economists and analysts' 11. Most continued to dance on the edge of the abyss, but in the company, and if they do not make more mistakes, their career, seven-digit salaries and bonuses were safe, that they miss the bus with all the impending crisis, not the grounds for their dismissal. Keynes for another example of the 1930s ironically summarized this point: "A good banker, alas, is not one who foresees danger and avoids it, but one who, having survived the collapse, it is experiencing a common and proper manner with their colleagues, that no one can in some way to blame "12. Financial market - this is, of course, a mirror of the economy, but it is very crooked, distorted, and the lack of information asymmetry, unpredictable and rare, but not impossible events, individual and collective irrationality, fraud and distorted motivation of market professionals. Calculate and predict the dynamics of the market - a task that is really very similar to the calculation of human folly. 1 Fama, Eugene (1970). «Efficient Capital Markets: A Review of Theory and Empirical Work». Journal of Finance 25 (2): 383-417. 2 Haldane, Andrew (2009). «Rethinking the financial network». Speech delivered at the Financial Student Association (FSA), Amsterdam. 3 Taleb, Nassim (2002). "Fooled by Randomness. Hidden role of chance in the markets and in life. " - M.: Internet trading. 4 Lowenstein, Roger (2000). «When Genius Failed: The Rise and Fall of Long-Term Capital Management». 5 Haldane, Andrew. (2009). «Why Banks Failed the Stress Test». 43.