Wednesday, November 18, 2009

Textbook Theories vs. Reality

Real world experience often brings to light academic fallacies, especially when it comes to the financial markets. Right off the bat, many business students here (Auckland) are taught that inefficiencies do not exist, or impossible to exploit; which completely disengages from reality.

Textbook theories vs. empirical reality

Just because an idea shows up in a textbook does not make it absolute truth. A widely known phenomenon, while Black-Scholes PDE presents an elegant option pricing formula, the “volatility smile” noticeably points out the formula’s inaccuracy and hence unreliability. Some may say “well, it’s all I got, better than nothing right?” No, a wrong solution is often WORSE than nothing.

Remember how the stochastic finance stock pricing model completely ignores credit risk and actual rate of inflation? Models like this have simply no practicality in actual trading.

Textbook contradictions (efficiency vs. inefficiency)

They do not even agree among each other. While some academics keep pushing Efficient Market Hypothesis, top business schools like Wharton use texts specifically on exploiting market inefficiencies like Understanding Arbitrage: An Intuitive Approach to Financial Analysis. What is up with that?!

Searching for truth

Knowledge requires actual experience, not just sometimes subjective ideas off some random textbook. It takes work, like everything else in life.

0 Reflections: