Academics who study finance but don’t actually work in the field have developed two main views of financial markets:
- Information aggregation: Economists tend to treat financial markets as mechanisms for evaluating information and using it to set prices, which in turn regulate economic activity.
- Random walk: Finance professors tend to treat markets as random walks. In a random walk, future price movements don’t depend on past movements. The metaphor is a drunk person taking each step in a randomly chosen direction, as opposed to a sober person whose steps can be predicted by the path she’s on. Of course, these finance professors don’t deny that markets process information and set prices, but if today’s price incorporates everything known today, then the move to tomorrow’s price must be unpredictable, or random.
A third view of financial markets is seldom taught in universities, at least not in economics departments and business schools. This third view holds that financial markets are a game – a claim usually made by critics of markets. Financial markets are a casino, a legalised form of gambling with financial institutions getting rich by taking a small edge from everyone’s bets; or financial markets are a rigged game designed to separate customers from their money; or financial markets are a playground for rich insiders to wreak havoc on the real economy.
Although all three views have their uses in risk management, the information aggregation and random walk views are more suited to trading, portfolio management and other risk-taking businesses. Modern financial risk management is more concerned with the game-like aspects of financial markets. More important than preferring any one view, however, is to make sure that you keep all three views in mind at all times. Concentrating exclusively on any one view guarantees that you are blindsided by one of the others.
If you believe that markets aggregate economic information, you expect prices to reflect reality. They move in response to news and to changes in supply and demand. These movements may be hard to predict before the fact, but they should be explicable afterwards. Most of the time prices should move smoothly, and the range of possible movement should be calculable. The big risks are sudden changes such as crashes, liquidity squeezes and realignments; deviations from rationality such as bubbles, panics and intervention; and miscalculation. This view of risk is popular in academic circles, mainly because it provides a lot of material to teach. However, it remains a minor aspect of practising financial risk managers.
If markets are random walks, there’s no point is trying to predict price movements beforehand or to explain them after the fact. Instead, risk managers should focus on the probability distribution of future price movements. The big risk is getting an extreme outcome that was assigned negligible probability beforehand. Front-line risktakers have responsibility for accurately estimating probabilities for known risks. Risk managers concentrate on the plausible extreme outcomes, which are events too rare or too extreme to put faith in any probability calculation, but that may happen and that would have extreme impact if they did.
In both of these views, the financial market is impersonal. It doesn’t know who you are or what you want. However, financial markets are composed of people, and some of those people do know who you are and what you want. Moreover, groups of people can interact to produce results that aren’t explainable in fundamental economic terms or in terms of random draws from impersonal probability distributions.
Risk management in a game can be quite different than managing impersonal risks. When nature is choosing the outcomes, you can usually tell how to reduce risk. When playing with people, on the other hand, building a defence may invite attack, and success can encourage others to ally against you.
Most investors in the stock market are long investors—they buy stocks they think will go up, so they can sell them later at the higher price. Short sellers reverse the order; they sell stocks they think will go down, so they can buy them back later at a lower price. If you think of markets as aggregators of information, short sellers are the same as the long investors; they’re just expressing opposite opinions about whether the stock is overvalued or undervalued. If stock prices are a random walk, the short seller’s return has the same probability distribution as the long investor’s return, just with the sign reversed. So, short sales and long investments are managed the same way with respect to risk.
However, anyone involved in equity markets knows that short sellers have much greater risks than long investors. One major reason is short squeezes. These squeezes occur when market participants decide that short sellers are too weak to accept large losses on their positions and that if the price starts to go up, short sellers are forced to cover—that is, to buy back the stock they sold earlier, closing out their position. This stock purchase pushes the price up higher, which forces more short covering, and eventually results in large profits for the buyers and large losses for the short sellers. Notice that the short squeeze has nothing to do with the economic value of the company, and it was not a random walk of any sort. It was based on perceived weakness of the short sellers. …
Imagine a world with no organised stock market. Companies issue stock and people buy it, but they don’t buy much. Companies cannot easily find buyers for their stock, and those buyers cannot count on selling the stock if they need the money later. No one likes to transact, because it can be hard to estimate the value of the securities. The economy is stalled because businesses don’t have easy access to cheap capital, and investors don’t have easy access to attractive diversified investments. This scenario describes most of the world for most of human history.
A bunch of people gather somewhere, say under a buttonwood tree in lower Manhattan. Some of them are portfolio managers who own stock but would like to trade it for stock in another company. In other words, they think that stock A is worth more than stock B, but without knowing the absolute price for either stock, they have trouble transacting. Other people have information. That is, they think that stock A will be worth more tomorrow than today, but they don’t know the value today, and they can’t be sure of finding a buyer tomorrow. Even if they can find a buyer, they aren’t sure that the price tomorrow will fairly incorporate their information. The result is that no liquidity, no price setting and no information are brought to market.
One other person happens to wander by that day—a gambler. She knows even less about the value of stocks than anyone else, but she’s a keen judge of people. More importantly, she enjoys taking a risk. Meandering through the crowd, noticing body language and voice tone, she concludes that there were more people there who wanted to buy stock A than to sell it.
She picks a price at random, and starts offering to buy stock A for £10. No one was anxious to transact, but everyone was interested in observing a live buyer. The fact that she could find no sellers for £10 told everyone that stock A must be worth at least that much, which added to the crowd’s net buying interest.
Eventually the gambler bought some shares for £12, and started offering to buy for £13. As the price went up, more people sold, but more other people started offering to buy. The price rapidly went up to £60.
At this point, the gambler sensed the mood turning. Many of the buyers already had the amount of stock they wanted, and the holdouts weren’t going to come into the market any time soon. Lots of sellers had been watching the price go steadily up, so the gambler knew that at the first sign of reversal there would be a rush to sell. So the gambler slowly and quietly began to sell her accumulated stocks. The price tumbled down to £25, at which point there was another reversal. After a few wild oscillations, a steady market for the stock settled down around £40, and which point there were roughly equal numbers of buyers and sellers.
From that day forward, stocks were much more valuable, because their value could be determined quickly, and they could be easily converted to cash at a fair price. It paid to bring information to market, so prices were also informed. However, occasionally liquidity would dry up due to sudden news, shifts in investor mood or large uncertainties. So a healthy population of gamblers hung around the market ready to earn money returning it to liquidity aftershocks.
Of course this story isn’t literally true, but it explains a few important facts about financial markets:
- Traders usually have only superficial information about what they trade, and often not even that. They look and act more like gamblers than like investment analysts.
- Financial market prices are far more volatile than can be reasonably explained by changes in fundamental economic information.
- Market prices are not particularly accurate when measured against economic value calculations or supply-and-demand analyses, but they’re extremely fair in the sense that people find it hugely difficult to make consistent money predicting their future course.
- Wherever they’re introduced successfully, financial markets touch off explosive economic innovation and growth.
The other important takeaway from this story is that markets serve their function by setting prices investors regard as fair, whether or not those prices make much economic sense. Of course the situation is better if the prices are rational, but that’s less important than that people accept them for trading—and that is less important than that a price exists at all. With prices and active trading, financial markets are a major driver of economic growth and a means for the majority of the population to earn financial security through their own efforts.
For a financial risk manager, the important thing to remember is that many aspects of financial markets are designed to make trading in them fair rather than to link prices to economic reality—just as aspects of trials and elections are there for fairness rather than to ensure justice or guarantee wise leadership. You can be absolutely correct in your economic analysis and estimate the probability distribution of future price movements perfectly and still go broke because the market outplayed you. In fact, precisely this experience is what led people to invent modern financial risk management.