The division between academic economics and the way traders look at the market is deep. The efficient market hypothesis assumes that markets and valuations are always pushing towards an equilibrium, and evidence to the contrary gets pushed aside as fluctuations or statistical deviations. But the dot com bubble, the 2008 financial crisis, and other boom-bust cycles before them make this assumption hard to believe, and the world’s most successful traders clearly don’t behave as if the market is a rational machine tending toward truth. Still, the division between theory and practice is so fundamental, it would be like engineers and physicists arguing over the existence of gravity


Fallibility, reflexivity, and uncertainty

George Soros has tried to cross over, putting his practical understanding of the market into academic turns in an article for the Journal of Economic Methodology. Instead of assuming efficient markets, he starts with the notion of fallibility.

“Market prices of financial assets do not accurately reflect their fundamental value because they do not even aim to do so. Prices reflect market participants’ expectations of future market prices,” he writes. On some level it doesn’t matter what the underlying assets are really worth, if you always knew which way the market was headed you would make a killing.

But traders aren’t casual observers, they interact with the market and can impact the prices they’re betting on (some more than others), and they aren’t the only ones. Governments and regulatory bodies are also trying to affect the market based on what they think is going to happen in the future. The impact that someone’s beliefs have on the market is what Soros calls reflexivity, but that’s also difficult to model because it doesn’t necessarily pull the market in the desired direction. Shorting a stock might pull its price down, but it might also cause other traders to initiate a short squeeze, and either way the expression of an opinion on the market (placing the short) affected the market itself.

Finally, Soros argues that markets are full of ‘human uncertainty’. While everyone accepts that there is risk – many different outcomes are possible with varying probabilities, and the laws of statistics serve us well in dealing with them – uncertainty is a different animal altogether. Uncertainty means that we don’t know all of the possible futures states, and we certainly don’t know their relative probabilities. Risk is an attempt to model uncertainty, but it necessarily falls short.

Economists suffer from physics envy: Soros

Soros’ assumptions sound like common sense to most people who have experience following the market, but that’s also why the current situation is so strange: what seems intuitively clear to traders isn’t even accepted by most academics.

“Mainstream economics tried to seal itself off from reality by relying on postulates that turned out to be far removed from reality,” writes Soros. “The achievements of natural science, exemplified by Newtonian physics, were so alluring that economists and other social scientists have tried incredibly hard to establish such generalizations. They suffered from what I like to call ‘physics envy.’”

Soros argues that the efficient market hypothesis is popular not because it is true, but because it allows for economists to make progress developing theories, while fallibility, reflexivity, and uncertainty are a far more challenging starting point. His point of view not only allows for boom-bust cycles and financial crashes, it expects them to occur. Until economics bases its assumptions on market observations instead of useful simplifications, he’s skeptical that it will make any real headway, and the physicists that Soros says economists style themselves after would agree.

“Social science is an example of a science which is not a science,” Nobel Prize winning physicist Richard Feynman once said in an interview. “I have the advantage of having found out how hard it is to get to really know something, how careful you have to be about checking the experiments, how easy it is to make mistakes and fool yourself.”