How Physics Solved Your Wealth Problem!
18 Pages Posted: 11 Oct 2016 Last revised: 8 Aug 2017
Date Written: October 8, 2016
While Robert Solow suggested not to think of Economics as Science, Andrew Lo warned us about the dangers of using Physics to build economic systems. Physics has been a late entrant to the world of Finance. The subject has reached critical mass to answer some of the biggest challenges of Finance of the last 50 years. The Nobel Prize-winning Finance has failed to reconcile efficiency and inefficiency, forcing the global money to rely on the Efficient Market Hypothesis (EMH) as the last standing hypothesis, which can neither be rejected nor accepted. This has left trillions of dollars in Pension funds clueless regarding what to rely on. The consequence could be an unintended risk, which society is not prepared for.
Though Smart Beta has brought in a rule-based thinking, it is primarily catering as an ‘Active’ solution to changing market cycles. Its foundation of financial theories remains structurally weak, the reason the industry does not have a coherent definition of the term Smart Beta. There is Factor proliferation, conflicting explanations of outperformance, lack of differentiation and a host of unanswered questions like why naive allocation is better than Factor selection? Is Multi-Factor better than Single Factor? Is everything that concentrates exposure of Market Capitalization (MCAP), smart? Whether timing helps or not? And larger questions like what drives the persistence of Premia? Will we ever take on Granger’s (1992) challenge to build a better alternative to EMH? The solution providers are simply riding on the growth of the segment relying on their institutional clients to comprehend the risk and invest.
Finance needs Physics to bring the needed clarity, usher in a simplified Factor thinking, move away from causal thinking and look at markets in a very objective quantifiable way to answer the various questions and explain the need and persistence of Free Lunch (Premia). The author makes the case by restating market Alpha as a process driven by the ‘Reversion - Diversion’ Framework that is at the heart of the ‘Rich Get Richer’ phenomenon. The paper explains how a simple probabilistic classification can address the insufficiencies of a behavioral or market efficiency model, explain how Smart and Dumb Beta work together and how Physics and the science of complex networks can be the savior for Finance.
Keywords: Economics, Finance, Physics, Probability, Market Efficiency, Market Inefficiency, Behavioral Finance, Mean Reversion, Pareto, Power Laws, Efficient Market Hypothesis, Smart Beta, Dumb Beta
JEL Classification: A00, A10
Suggested Citation: Suggested Citation