Chapter 3 - Random walks
from Part I - Background for analysis
Published online by Cambridge University Press: 05 May 2014
Summary
When it comes to bubbles, economists have spent the last thirty years metaphorically gunning their engines, spinning their wheels, and going nowhere. This lack of progress may be attributed to many things, but certainly not to absence of applied intellectual or computational horsepower. The major underlying problem has been that it is impossible to pin down what is known as “fundamental value.” This difficulty is then compounded by the rather widespread underlying assumption that, when it comes to investment decisions, humans are by and large economically rational beings and examples of homo economicus – that is, unemotional trading automata unaffected by losses or gains from previous trades and investments and hermetically sealed off from the emotional “irrationalities” of other players in the markets.
The chapter reviews and explains why the random walk and efficient market hypotheses and capital asset pricing theories that have been developed and vigorously debated over the last fifty years do not readily accommodate notions of bubbles and crashes. The purpose, however, is not to engage in battle with proponents of these theories, nor is it to debunk, deny, or disrespect the theories themselves, which after all have greatly contributed to an understanding of the interplay between risks and rewards. It is just that these theories were not originally designed nor specifically intended to explain bubble and crash phenomena. The motivation is instead to suggest that another approach is needed in describing, defining, and measuring such extreme events.
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- Financial Market Bubbles and Crashes , pp. 60 - 76Publisher: Cambridge University PressPrint publication year: 2009