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How Theories can help or hinder your investing. October 18, 2012

Posted by shaferfinancial in Finance, paradigm shift.
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I have been a big critic of efficient market theory, still am. Here is a link to a book review that you might find interesting.

But the most recent theory [explanation] of human behavior that has caught my eye is chaos theory.
First described by a meteorologist, it is simply the idea that small, seemingly inconsequential variables, can create huge differences in outcome. Often the idea is explained by the thought that butterfly’s in a meadow in Asia can cause weather patterns over North America to deviate. In science “chaos” is described as underlying interconnectedness that exists in apparently unrelated events.

Moving from a rational theory like efficient market theory to a theory that states you can never totally record the variables that create change is a difficult one for investors. That is why EMT is held on so tightly by many. This scientistic culture that sees the world in terms of analysis, quantification, symmetry and mechanics has really created a prison of the mind or an allusion that we can control outcomes.

Embracing chaos theory is really embracing what we experience of the world. The first allusion that must be dealt a death blow is control. This is where the EMT has really led folks down a wrong path. The thought that by rational explanation one can create an investment strategy that will control risk is a faulty assumption as we got recently reminded. If we give up the thought of controlling all risk with a single investment strategy, then we can open ourselves up to a more creative and ultimately satisfying investment life.

As we see the devastation brought on to individuals retirements by adherence to these rational investment theories that didn’t account for the real risk [it was known] and certainly didn’t see the 2008 melt-down in all asset classes some folks have stepped away from the common strategies in surprising ways.

Unfortunately, many folks are simply ignoring the reality or so emotionally tied to the old ways of thinking that they can’t change. Worse, is the new generation of folks that are being pitched the same old tired ideas like buy term and invest the difference [in mutual funds] or asset allocation theories or buy and hold stocks that have failed. I am shocked when I talk to people who either don’t remember or have pushed 2008 out of their memory. Especially coming on the heels of 2000 tech break down. Did you know that in 2000 the Nasdaq was over 5000 and now resides at 3100+? People forget that in the 1990s tech stocks where all the rage and investing in the Nasdaq considered a no-brainer for indexers.

Truth is that the government and Wall Street have created a perfect storm convincing people to invest in stocks for their retirement. And small seemingly inconsequential variables will to continue to crop up and destroy those folks happiness.

Recently, I had someone tell me about a particular strategy where a relative had received double digit returns for 3 years. He also seem to indicate that double digit returns were a logical expectation. I didn’t ask him if that was 10-12-15 or 20%!

Expect the unexpected is the only rule to investing today. Don’t try to control it, just adjust your strategy assuming it will happen. Look for creative investing strategies even if that means taking on old ideas that were thrown on the dust bin of history by the experts pushing mutual funds, asset allocation, etc.

In the near future I will explore what this all means to me and why I have done the things I have done for my finances.

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Comments»

1. gregturn - October 18, 2012

I have always found the emergence of quantum theory over the past century as an amazing realization that many things all around us can only be pinned down as probabilities and not a wound up clock with a fixed pattern. Many people, including Einstein, were hesitant to accept this, but it has born out so many observations, that it is commonly accepted. We are still trying to grok what it means in a Big Picture sense.

How long will it take before things like the EMH are finally discarded for good, and people must instead account for wild emotions, small variables, and blind economic models that become obsolete as more people understand them? Your socratic approach of “sticking to the evidence” is the only path through all this malaise, something that has been the means to develop knowledge over thousands of years.


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