Economists Do It With Models

Warning: “graphic” content…

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Boston Quantitative Forum, October 11, 2012

Hi all! I’ve posted some helpful links to go with the behavioral economics/finance BQF presentation. In addition, you can see an animated version of the slides below. Before we get to that, however, I wanted to follow up with a more detailed answer to a common question from the event.

Obviously, given the nature of the event, attendees (rightfully) put a high priority on the “actionability” or “investibility” of all of the information that they are given. In my view, one of the key prerequisites for designing successful investment strategies (arbitrage or otherwise) is to understand as much as possible about the markets that one is investing in. This process is initially mostly descriptive in nature, but to do otherwise would be putting the cart before the horse. After an anomaly or irrationality (read, potential opportunity) has been identified, the next step is to try to understand why it’s happening in the market. Due to the nature of their business, this is generally where academics stop, and I am not going to even come close to claiming to give investment advice (though people like to ask all the time because they think that that is what economists do).

From an investment perspective, therefore, the next step is to identify why an opportunity isn’t getting arbitraged (or at least invested) away and then to consider whether you or your firm is in a position to take advantage of opportunities that others can’t. These advantages could be due to differences in institutional or other restrictions on investing (not being able to short a closed-end fund, for example), differences in information processing capabilities (or different information, for that matter), differences in investor time horizons (i.e. lock-up periods), differences in borrowing rates, and so on. As a result, there may be cases where you can creatively design alpha-generating strategies where others can’t and thus reap the benefits of your behavioral finance knowledge. On the flip side, if you understand why certain market anomalies aren’t getting arbitraged away, you can avoid getting into positions that are not sustainable for your firm. (LTCM, I’m talking to you.) Nonetheless, the quest for profit opportunities start (or, at least, should start) with an understanding of market imperfections and the reasons behind them. Otherwise, you’re just noticing patterns and hoping that the patterns continue (or reverse themselves, as the case may be), which we’ve been shown can be a risky endeavor.

Anyway, back to the slides…

(Note: To advance properly through the animation, just wait a few seconds for the pause button to turn back to a play button and click forward. If you are experiencing difficulties, you probably need to install the latest versions of Flash and Shockwave from Adobe.)

I hope this is helpful, and feel free to send follow up questions my way at econgirl at economistsdoitwithmodels dot com.

1 Comment

1 response so far ↓

  • 1 Krishnamurthy Prabhakar // Jan 13, 2014 at 9:48 pm

    Dear Madam, Greetings. Thank you very much for your posting. The list is comprehensive and useful for my class.

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