Self-fulfilling prophecies in finance & arbitrage
I was reading Soros' paper on the theory of reflexivity and it lead me to an interesting chain of thoughts about the validity of many finance theories used in practice and whatnot.
My conclusion was that many aspects of finance are somewhat of a self-fulfilling prophecy. Just to take some examples:
We agree that the valuation of a company is done based on the widespread methods out there (DCF, Comp, etc.), and when 2 parties negotiate the price they use the same method - thus the price paid is just a reflection of a mutually shared theory by both parties (which may be inaccurate in reality).
Another example: The price of the unhyped equity and bonds in the market generally reflect a consensus price that is concluded based on the same theories shared among the analysts. There's no innate value, it's a value derived from theories.
Another example: The price of options or other derivatives is also determined based on some generally shared formulas among professionals.
If it's not clear, the idea is that the prices we see reflected in the market are determined based on human judgment (including theories) but we have no guarantee that this theory is a definitive one, in the future, it may be false; in other words, there's no certitude that the price given to those assets is the correct one, it only reflects that the price given to those assets is correct if we agree that the theories out there contribute in reflecting an asset's value (keyword: if):
seller: theory --> price --> price agreed to be fair based on theory --> sells --> theory enforced because the theory contributed to selling it at X price
buyer: theory --> valuation --> price agreed to be fair based on theory --> buys --> theory enforced because the price of the asset was considered fair (but both buyer and seller used the same theory).
I understand the counterargument that there's no absolute truth in determining the value or the price of many assets because the price is strictly based on what a buyer agrees to pay. BUT, I think that there's a lot of room to improve many of those theories down the road. The models and theories existing nowadays may become outdated and replaced with better ones - it's just a matter of time. Furthermore, to be frank, many financiers are quite lazy thinkers, that's why it's hard to find stellar investors. You need to approach investing metaphysically, and not solely put into practice commonly shared theories (just execute what the CFA thought you).
Moreover, in the same chain of thoughts, beating the market is considered impossible because it assumes that your method of approaching the market follows the same thought pattern and theories instilled in millions of finance students and financiers worldwide. If you approach investing with the techniques learned in finance textbooks and school, your only way of making money is arbitrage, i.e., spotting mispricing before others, because you all play with the same toolkit. So if anyone out there may want to challenge the current academic world and the consensus of the masses and his theory holds up then that's the only way to "beat the market". Otherwise, we're just doing arbitrage. And I think that there are opportunities to improve many of those theories and exploit them, because as it was proven endlessly what's thought in academia =/= practice. In other words, the vast majority of theories were invented in classrooms, so the opportunities belong in those places where theories are invented in HF offices (but make no mistake: theories =/= forecasts).
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