Hubble, Bubble, Index Trouble

Consequences, Consequences

In a world in which our behavioral biases are continually encouraging us to stray into temptation, or at least into the grasping hands of the securities industry, we have to look for whatever small mercies we can find. Not the least amongst these is the humble index tracking fund, an asset type specifically created to minimise the opportunity for self-inflicted mischief.

Yet such is the nature of the financial business that even in the world of the behaviorally inert, passive index tracker we can’t avoid the dead hand of unintended consequences and cognitively induced misadventure. In becoming popular index tracking funds have simultaneously created their own behavioral problems: because whenever too much money imbued with too little intelligence chases too few assets the only possible outcome is a bubble. And we all know what happens with bubbles.

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Perpetual Novelty, Santa Fe Style

Learnings from Science

By the late 1980's there was a growing recognition that the existing understanding of financial systems was flawed. Not only did markets not behave as the economic theories predicted but they often exhibited behaviour that didn't seem to have any pattern or cause at all.

In response to this a number of economists began looking at some of the research emerging from physics, biology and computer science in the area of complex adaptive systems and this led, in 1987, to a group of economists and scientists getting together at the Santa Fe Institute. The program of work that came out of this seminal event is still unfolding today, but suggests why academics and traders have had such different views on markets: one set lives in the real world, and the other doesn't.  Wanna hazard a guess as to which is which?

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Soros’ Economic Reflexivity

Feedback in Cause and Effect

Social Psychology 101 stresses the interconnectedness of cause and effect in human mediated systems. It’s not just that cause begets effect but effect then begets cause which begets effect which … yeah, well, you get the idea.

The investor George Soros has taken this idea and used it to become mindbogglingly rich. He sees behavioral economics as only one part of a better description of our financial system: it explains how causes create effects but not how they feedback on each other. To explain that we need to look at what he calls economic reflexivity.

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Studying Economics Makes You Mean

Not Predictable

It’s established by now that economics didn’t help stop some of the more spectacular misadventures of the financial community but it’s a bit less obvious that it was directly responsible for many of the mishaps. It’s all tied up with the dirty fact that economists are basically a bunch of untrustworthy, deceitful bums who shouldn’t be left alone with your child’s piggybank, let alone the world’s economy.

The trouble is that economists have a world-view that sees us all as self-interested moneygrubbers without an ethical thought in our heads. Perhaps that’s because that’s a pretty good description of economists themselves: they act like their models are true, the dirty rotten scoundrels.

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