When it comes to studying the financial markets all we have is history. Indeed academic finance is built on studying various relationships in historical data. Which on the face of it makes sense. The problem is the world doesn’t stand still. The world changes and so do the facts associated with it.
Mark Rzepczynski writing at Disciplined Systematic Global Macro Views talks about this idea relative to the insights from Samuel Arbesman’s book The Half-Life of Facts: Why Everything We Know Has an Expiration Date. Rzepczynski notes we should still study facts but we have to put into perspective. He writes:
The academic studies of the past will likely be overturned. The ideas that drove investment decisions a decade ago may not be true today. Our common knowledge may be wrong. Assumptions concerning market behavior are subject to change. This half-life of finance facts creates potential for investment failure. For those that are gathering and assessing new facts, there is opportunity for profits, at least for a time.
People adapt. They adjust their behavior based upon new information. So market relationships change.
It is this process that Andrew Lo talks about in his book The Adaptive Market Hypothesis: Evolution at the Speed of Thought. The financial markets are a stew of behavior and adaptation based upon all manner of ‘social, cultural, political, and economic’ forces. If these underlying conditions were unchanging, then the markets would be easy. Whatever worked in the past would work again. That’s obviously not true. In an excerpt from the book Lo writes:
Under the Adaptive Markets Hypothesis, individuals never know for sure whether their current heuristic is “good enough.” They come to this conclusion through trial and error. Individuals make choices based on their past experience and their “best guess” as to what might be optimal, and they learn by receiving positive or negative reinforcement from the outcomes.
Because markets change, behaviors that were once seemingly rational and adaptive can go out of sync with the environment. Ben Carlson at A Wealth of Common Sense in a recent post noted research showing the rising amount of investment companies now put into intangible assets relative to tangible assets. This changing relationship, and static accounting rules, throw all manner of previous relationships out of whack. What seemed reasonable before no longer does. Carlson writes:
This is not to say the stock market can’t or won’t fall from here. It certainly can and will at some point. But if you’re using economic or market relationships from the past with no context about how things have changed with the market and economy, your models are basically useless.
One response to all this is to throw up your hands in frustration. Once you learn something you think to be true, it can very well be untrue already. Technology seems only to be accelerating this process. All you can really do is try to become a learning machine and adapt as best you can to our changing reality.