Two of the most destructive forces for the economy are the words “let’s suppose” and the use of the = sign. When we put the two together, they form a combustible combination that gives seemingly well-intentioned and rational investors the power to disintegrate assets at will. This is because investors have a desperate need for quantitative models that will justify or ‘prove’ their investment theses, if for no other reason than it provides much better job security than having an investment thesis based on their good judgment and common sense. Unfortunately, this state of affairs gives rise to some of the most egregious misuses of the scientific method that one could imagine.
For example, let’s suppose that 8 pumpkin pies = ½ of a new Cadillac CTS. Therefore, 16 pumpkin pies = 1 Cadillac CTS. Why not? As I sit in my office, I suppose that 1 lamp = 1 roll of tape, and therefore if I buy 5 rolls of tape, the equation is 5 rolls of tape = 1 current lamp + 4 more lamps. When we “suppose” in order to use an = sign, we can turn an outrageous and silly statement into a scientific formula that sounds persuasive.
Let’s try some other assumptions on for size…
Let’s suppose that investors have perfect structural knowledge, meaning that they know why prices change today and in the future. Let’s also suppose that they have perfect economic foresight, meaning that they know perfectly how current news will impact future prices. Then our equation becomes: Today’s Prices + News = Future Prices. That may sound impressive, but we might as well be talking about pumpkins and Cadillacs. Assumptions like these carry a high burden of proof that they be correct.
How about these assumptions?
- U.S. residential real estate prices never go down in value.
- Markets always function normally, so standard deviation properly measures risk.
- Investor behavior doesn’t impact markets, so price changes can be measured by the same method used to measure the movement of grains of pollen in water (Brownian Motion).
The assumptions go on and on: The market is always in equilibrium except for the news… investors have the same risk tolerance… the same access to information… the same indifference to taxes… investors can borrow at the risk-free rate… etc. These are the basic assumptions used to justify the rational expectations pricing model, which is known to most investors as the efficient markets hypothesis. It is a powerful and troubling example of what happens when the words “let’s suppose” get followed by an = sign, and is usually a recipe for financial mischief.
[I first wrote and published this column on June 8, 2009, but it’s an important one, so I’m reposting it now.]