Towards a unified theory of finance
Posted on January 27, 2009 by Richard Beddard
Filed Under Investing, Markets |
Visionary spotted on YouTube
I’ve been watching Robert Shiller lecturing1 Google employees on the subprime crisis, the subject of his recent book, trying to reconcile his faith in finance theory…
Maybe it’s because I’m trained in finance. I believe in financial theory and that there’s a technology we have to adapt. And actually the crisis ought to be considered a failure to apply risk management theory.
…with the fact that Professor Shiller is one of the world’s leading experts on bubbles, the latest two, involving technology stocks and houses, demonstrating so obviously that financial markets are anything but rational as finance theory might suppose.
Along with greedy bankers, lackadaisical regulators, craven politicians, unthinking journalists, thick consumers and credulous investors, finance theory is one the villains of the credit crunch. Stockmarket events as extreme as those in the last year are just not supposed to happen, which goes some of the way to explaining how we were so easily caught out.
When Shiller’s using the Shanghai Composite Index to illustrate a bubble bursting, he doesn’t seem to be a fan of efficient markets, one of the planks of finance theory:
You can see what’s been happening in China. The stockmarket was drifting along here. Then around 2006 it went up five-fold. And then, bang! Just look at that! We teach our students about random walks. This could happen. A random walk could do this and I don’t want to be quick to dismiss any theory but it seems like it’s probably useful to think about some kind of psychological cause.
The stockmarket bubble that ended in the 2000, the year Professor Shiller published Irrational Exuberance, the book that made him famous, was also behavioural:
In my 2000 book, I talked about the arrival of the internet as a precipitating factor for the arrival of the bubble… It created a sense of a new era that was coming. Now that sounds kind of silly. Why should a sense of those events have such a big impact on the market? But remember we’re talking behavioural economics and not rational economics.
The financial theory he’s talking about is not the rational financial theory of Markowitz , Sharpe and Miller exclusively, it’s also informed by behavioural finance, or “animal spirits”.
I’ve touched on the first half of the lecture. In the second half, he speaks about what we should do, and it’s unlikely to involve more home ownership:
We are in a mess I think. What we have done, largely because of our complacency generated by these bubbles, we’ve put people in a situation where they managed risk terribly. Let’s start with individual homeowners. It became enlightened wisdom that most people should put their life savings into an investment in one city and leverage it up 90% or more. Now, if you did that with the stockmarket. If you told your friends I’m going to buy one company stock and… Margin it up 90%… people would say you’re crazy.
His first solution is state funded financial advice, which sounds like a good idea, assuming the state understands finance as well as the Professor (there’s not much evidence of that!). Then he talks about more financial innovation, which sounds good in theory and downright scary in practice.
We’ll learn more in his next book written with Nobel Prize winner George Akerlof and appropriately named Animal Spirits. In the mean time, I’ve discovered something even better, Professor Shiller’s entire econ 252 Financial Markets course free to download.
Footnotes:
- It’s an hour long, for a ten-minute interview see iBall interviews Robert Shiller.
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4 Responses to “Towards a unified theory of finance”
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The most important single point here (IMO) is one that I have been trying myself to get people to see for many years: the gearing and lack of diversification in house ownership.
The problem is not just that you are exposed to the risks of the housing market (bad enough given the gearing), but to the risks or owning one particular house.
You can insure against some risks (but I have twice come across people whose insurance turned out to be invalid or inadequate when I looked at it), but not others. What if a main road is built too near for comfort? What if an ugly block of flats is built across the road? What is the area’s reputation deteriorates? What if public transport worsens?
Of course, this does not mean that you should not buy a house. There are a lot of advantages to owning your home. Just be aware of the full range of risks, before you make a decision.
Just wanted to add that I think the idea of state funded financial advice does not sound like a good idea. People need to be told a lot of hard truths, and there is no political mileage to be had in telling people what they do not want to hear.
Would a state funded body have really spent the last few years telling people that they should be careful about investing in housing, or would they have been told to tone it down and stop undermining confidence in the economy?
nicely explained
Hi Graeme,
Great to hear from you again. On insuring the risks of home ownership, Shiller has lots of ideas and he’s putting them into practice by trying to create the markets he advocates. Basically he thinks homeowners should be able to buy hedges in other markets i.e. property indexes or indexes related to salaries in specific professions. It sounds complicated, and you’d certainly need advice! Although, I take your point that it might not be in the short-term interests of governments. Perhaps I should have said independent state funded financial advice, though how you achieve that, I don’t know