Financial markets seem to have a life of their own, unpredictable, capricious and inapprehensible to human reason. But is it really the case? And if so, what substance are they made of?
This disquisitions belong to one the main philosophical enquiries, the existence of the self and what surround us, which goes by the name of Ontology. This study branches out into three different realms: the physically observable universe, the mental sphere and the “meta” world (composed of abstract entities, like numbers, forms, values and the like).
In the case of financial “beings” the three previous categories are intermingled. Take a company’s stock as an example. They have a physical substrate (today an electronic record, in the past a bearer certificate), and grant their holders the right to receive dividends, as well as a final claim on their physical assets. However, these rights crucially depend on the common acceptance of a legal framework which exists only in the minds of individuals. Finally, many believe that its value is intrinsic in nature, which may differ from the observable external price.
In fact, the discussion on whether or not investors can beat the market resembles Heraclitus vs. Parmenides standoff on the immutability of things. Value investors, believing in fundamentals like Parmenides, regard companies as well-defined entities whose inner worth can be ascertained by means of abstract valuation models; if the market price of a stock is lower than its intrinsic value, you buy it, if it is higher, you sell it. On the contrary, for Heraclitus-type of investors (known in the jargon as believers in the “Efficient-Market” hypothesis) firms are in permanent flux, as consequence of both internal changes and adaptations to external information. Hence, every price reflects a different reality, or in Heraclitus’ parlance: “No man ever steps in the same river twice”.
This ontological problem can be extrapolated directly to other financial entities such as, money, interest rates or currencies. All of them are abstract artifacts that exist in our minds, but also have certain touching points with our physical reality. As such, they fall into what the constructionist school of thought defines as “socially constructed” entities, their existence being contingent upon a shared understanding by a group of individuals.
The intersubjective nature of financial markets is coupled with a well-known behavioral bias, the human need to build narratives. When we are faced with a random system – as financial markets are to a large extent – we tend to look for a chain of causality. In this regard, our own inference of “financial reality” is completely irrelevant, and the only thing that moves markets are the narratives that dominate the psyche of investors. Drawing an analogy, it does not matter if you think you’re handsome, that if the rest of the group thinks you’re ugly, then the reality is that you are ugly.
At this point, we inevitably fall into the arms of philosophical skepticism, since there is nothing we can know with certainty about the financial markets, which are nothing more than an exercise in “smoke and mirrors”. Fortunately, the Hegelian tradition offers us the synthesis (the promised lesson of philosophy to investors): we must know what can be known with certainty (data, policies, financial relationships) and thereby build our own scenarios; but you also have to decipher what others think they know, and bet accordingly; always maintaining a healthy skepticism about how far both the prevailing narratives and their own can differ from reality. Then, iterate again.
Fernando de Frutos, MWM Chief Investment Officer
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