Tuesday, August 16, 2011

A New Risk Paradigm

Click Here To Play The Video
In this interview with Ann Rutledge, she states that the financial concepts she studied at the University of Chicago were predicated on the notion of a risk-free rate.  With the Standard and Poors downgrade of U.S. debt, that notion becomes, in her words, a myth.

Same Asset; Different Risk
She thinks that if the U.S. debt is not risk-free, as was previously assumed, then it would be possible to use more than one model to determine asset risk.  If different people use different models with different assumptions, then that means there is no longer only one answer (as assumed for efficient markets theory because the efficient market theory assumes the market is aware of the information used to price an asset, so the price has to be correct since that information is known).

How Real Markets Work
I have always found that logic to be what is called "circular logic" in computer programming, but has been highly followed for many years.  If what Ann is saying is correct, then I take it to mean that different people, using different assumption would be willing to pay different prices for the same asset.  This sounds more like a real market to me.

This means the market does not always get the price correct, that the market is capable of mispricing assets.  This would also mean we can take advantage of situations where the market has mispriced an asset by buying low and selling higher.

Which Leads To...
To me, this is a perfect example of how the academic models, touted and flouted by the financial services industry as proof that "buy and hold" is the only approach that might possibly work, will continue to be disputed by actual experience.  It would prove that timing the market is more than merely being lucky, as they have tried to lead us to believe.

What do you think?  Might the financial services industry use out-dated academic models to support their "buy and hold" position?

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