We already refered to the book in the following review: The Alchemy of Finance, Really ?!
Highlights
On Markets, Science and Philosophy
Taking my passionate interest in the truth as a starting point, I can build a cople of interesting arguments on it. One will establish the merits of financial markets as a laboratory for the pursuit of truth, and the other will extoll the merits of philosophy.
Once you leave the confines of scientific method you are in constant danger of getting lost in a world of your own creation and leaving reality far behind.
The market is a harder taskmaster than academic debate.
The primary objective of science is the truth- that of alchemy, operational success (...) Operational success can be achieved without attaining scientific knowledge.
Markets themselves can be viewed as formulating hypotheses about the future and thensubmitting them to the test of the actual course of events. The hypotheses that survive the test are reinforced; those that fail are discarded. (...) Treating the market as a mechanism for testing hypotheses seems to be an effective hypothesis.
Financial markets bear a curious resemblance to scientific method: both involve the testing of hyoptheses. But there is a fundamental difference: in science, testing serves to establish the truth; in financial markets, the criterion is operational success.
Reflexivity
The possibility that stock market developments may affect the fortunes of the companies is left out of account.
Movements in stock prices are believed to precede the developments that subsequently justify them.
I do not accept the proposition that stock prices are a passive reflection of the underlying values, nor do I accept the proposition that the reflection tends to correspond to the underlying value. I contend that market valuations are always distorted; moreoover- and this is the crucial departure from equilibrium theory- the distortions can affect the underlying values. Stock prices are not merely passive reflections.
I regard changes in stock prices as part of a historical process and I focus on the discrepancy between the participants' expectations and the actual course of events as a causal factor in that process. (...) I claim that market participants are always biased in one way or another.
I replace the assertion that markets are always right with teo others:
1. Markets are always biased in one direction or another.
2. Markets can influence the events that they anticipate.
We have here a reflexive relationship in which stock prices are determined by two factors- underlying trend and prevailing bias- both of which are, in turn, influenced by stock prices.
Instead of fundamentals determining exchange rates, exhange rates have found a way of influencing the fundamentals.
Vicious and benign circles are a far cry from equilibrium.
The refexive action between the act of lending and the value of the collateral may then connect the "real" and the "financial" economy or it may be confined to the "financial" economy.
Models currently in use are based on the misconception that markets can only foreshadow events, they cannot shape them. My approach recognizes that financial markets can also precipitate or abort future events.
On Boom and Bust Cycles
Booms and busts are not symmetrical because, at the inception of a boom, both the volume of credit and the value of the collateral are at a minimum; at the time of the bust, both are at a maximum.
In abust, the reflexive interaction between loans and collateral becomes compressed within a very short time frame.
The fact that banks and organized financial markets are regulted complicates the course of events tremendously. Financial history is best interpreted as a reflexive process in which there are two sets of participants instead of one: competitors and regulators.
Stock-market booms are always associated with credit expansion. Excessive instability can be prevented only by some sort of regulation.
Trading Strategies and Markets Observations
We all live in a fantasy world. Having an affinity for abstract ideas, I am perhaps more apt to be carried away into a world of my own creation than many other people. The markets have always helped to preserve my sense of reality.
It has become fashionable to be a contrarian, but to bet against prevailing expectations is far from safe.
Prevailing opinion had linked the strength of the dollar to the strength of the conomy and to the interest rate differential. When the dollar refused to weaken, the last of the trend fighters gave up and the exchange rate went trough the roof.
It is more usual for me to operate with two at least partially contradictory theses than to stake everything on one thesis. As a general principle, I do not dismantle positions that are built on a thesis that remains valid; rather, I take additional positions in the opposite direction on the basis of th new thesis. The result is a delicate balance that needs to be adjusted from moment ot moment.
I prefer to retrench all around when things begin to go wrong. Two weeks of active activity produced no results: it is time to become more quietscent. I am still too much involved in the day-to-day movement of the market, but I shall try to regain my perspective. With reduced exposure, I can reassess and regroup more easily.
Profesional investors have raised a lot of cash and done a lo of hedging. If there is going to be a surprise it will be on the upside.
The bubble is not yet ripe for bursting.
The very expression "portfolio insurance" is a false metaphor because it is based on an analogy with life insurance; but death is certain, while a crash is not. A rally in the stock market would show up the flaw in portfolio insurance; afterwards, the market would be in a better position to decline.
On Markets Forecasts
My greatest weakness was in economic forecasting.
Events are notoriously more difficult to predict than to explain. How can one anticipate decisions that have not yet been taken?
My financial success stands in stark contrast with my ability to forecast events. In this context, we must distinguish between events in financial markets and events in the real world. Events in financial markets determine financial success; events in the real world are relevant only in evaluating the scientific merit of my approach.
By the time I recognized a market trend and formulated a hypothesis to explain it, the trend had already changed and I had to find a new hypothesis.
On Efficient Markets and Equilibrium
Equilibrium is supposed to ensure the optimum allocation of resources. (...) we have no grounds for believing that markets optimize anything.
The contention of classical economic theory that the market mechanism assures the optimum allocation of resources is false; its true merit is that it provides a criterion by which the participants can recognize their own misconceptions.
The more the theory of efficient markets is believed, the less efficient the markets become.
Market Participants
The structure of events that have no thinking participants is simple: one fact follows another in an unending causal chain. The presence of thinking participants complicates the structure of events enormously: the participants' thinking affects the course of events and the course of events affects the participants' thinking. To make matters worse, participants influence and affect each other.
Thus the causal chain does not lead directly from fact to fact but from fact to perception and from perception to fact with all kinds of additional connections between participants that are not reflected fully in the facts.
When the course of events is influenced by the participants' bias, future events are open to manipulation by observers in a way that is not possible in natural science. (...) since unable to influence natural phenomena, the social sciences face a problem that has no parallel in the natural sciences.
The avowed purpose of science is the pursuit of truth; but when the subject matter is open to manipulation, participants may be more interested in changing the course of events than in understanding it.
It is not easy to make sense of the process: many people participate with only a vague idea of what is going on.
