The below paper was an assignment for my English class this semester, therefore the style is quite a bit different than that in which is usually on this website. However, I still wanted to share it with you because it related to my trading and the financial markets. Let me know if you have any questions. 

 

Ben C. Banks  Econophysics and it’s Lamentable Stalling

Econophysics–the combination of economics and physics–offers us a much-needed new look at widely-accepted finance industry concepts like the theory of efficient markets. However, if econophysics is to broaden its reach and provide new factual knowledge, physicists and economists need to learn to collaborate, by sharing knowledge, in a understanding manner for the benefit of all parties.

If the Efficient Market Hypothesis is true, there is zero reason to hire a financial advisor as there they have no potential to produce any higher return than purchasing the ‘market’ itself. Standard economic theory says that the price movements in the financial markets are normally distributed. Consequently, the Efficient Market Hypothesis (EMH) was created by economists to explain the incapability of consistently achieving returns higher than the broad market indices. Specifically, EMH, via Investopedia, states “it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments.” With the introduction of econophysics, this foundation of economic theory is now being questioned. Econophysics is the revolutionary study of the integration of physics concepts into economics, specifically the financial markets. The purpose of econophysics is to study the dynamic and complex behavior of the financial markets, including the efficient market hypothesis. There has been little tenable research in terms of the actual movements of the markets. Up until recently, the movement was attributed to be random and normally distributed, however, with the introduction of econophysics, new empirical data emerged with a different explanation of price movements allowing for a more precise description of the ‘why’ behind price movements within the financial markets. Econophysics–the combination of economics and physics–offers us a much-needed new look at widely-accepted finance industry concepts like the theory of efficient markets. However, if econophysics is to broaden its reach and provide new factual knowledge, physicists and economists need to learn to collaborate, by sharing knowledge, in a understanding manner for the benefit of all parties.

I believe econophysics is a reliable field of study because it is fundamentally based in mathematics, which allows for a new perspective on our finances. All consumers (you, I, financial advisors) want to have accurate information about how their money is being used. This study offers revolutionary knowledge on the dynamics of the markets, allowing for better economic decision making.! Which is what we all truly want! Econophysics is very new field of study, especially relative to most other common scientific fields. The study of econophysics technically began in 1996 (Franck & Schinckus, 444), but the first physics concept applied to the financial markets occurred as early as the 1970’s. The limited research at this point in history created many assumptions, thus creating the fundamental economic theory. Any theory fundamentally based upon assumptions is logically flawed. Therefore, the current, well revered economic theory holds the “burden of proof” in regards to support for their theoretical claims (ex. EMH). From the dawn of research for financial markets, mathematical studies and financial economies have progressively diverted away from one another, both coming to drastically different conclusions (Franck & Schinckus, 451). For the commonly known study, financial economics, the research is based on the assumptions of rationality, normally distributed returns and the market’s ability to be ‘efficient’. On the other hand, the mathematics (econophysics) explanation of market movements is based upon empirical data that examined without the baggage of prior assumptions.

Some may say econophysics is a ‘mystical genie know-it-all’ formula, but that’s false; it is a more accurate representation of the data we presently have compiled. “Econophysicists do not contend that they are attempting to integrate physics concepts into financial economics, but rather that they are seeking to replace the theoretical framework that currently dominates with a new framework derived directly from statistical physics.” (Franck & Schinckus, 446) The financial managers that we hire to manage our money are operating under the assumed theories of economics and need to be, at a minimum, aware of how the given theories were conceived, to prove the legitimacy (or not) of their operations – for our sake! The historical style of examining the financial markets is a-world-away from the new way econophysics is answering the same questions. In their article, “The Emergence of Econophysics: A New Approach in Modern Financial Theory”, Franck Jovanovic and Christophe Schinckus describe the difference as being a “fundamentally new approach”. The authors go into depth into the fundamental differences between the two types of analysis, explaining that the “practitioners are not economists taking their inspiration from the work of physicists to develop their discipline, as has been seen repeatedly in the history of economics. This time, it is physicists who are going beyond the boundaries of their discipline, using their methods to study various problems thrown up by the social sciences.” We all need econophysics to allow us to grow our money in a more effective manner. It is not a spiteful attack on economists.

Many already believe physics can be applied to a diverse range of topics, including everything from bugs to traffic. Currently a disconnect between present economics and physics and their seeming incompatibility is stalling the development of econophysics as a viable field of study. Some physicists, subjectively, contend that physics applied to social sciences is not in fact ‘real physics’. This argument is logically flawed as one cannot accept the un-‘real physics’ argument while still accept applicability of physics to traffic patterns, and insects (Econophysics Matter, 1).The zero irrefutable evidence for the support of the continued division between economics and physics should be enough to continue this study. Especially given all that physics has already accomplished (ie. establishing that markets are not normally distributed).

Through coordinated interdisciplinary collaboration, this disconnect can be resolved, opening the door for the expansion of econophysics. I think some economists need to accept that they may not have all the answers and treat the study of their field as a playground, a place to experiment, grow and become more knowledgeable. On the other side of the spectrum, physicists assignment is to treat the application of physics to economics delicately and recognize the large contrast between the study of both economics and physics. Both parties have equal responsibility to enact their knowledge and expertise with humility and respect, while being focused that a greater understanding of financial markets will benefit everyone. A new interdisciplinary journal, joint-conferences, joint-classrooms at universities, open discussions are all very tangible actions economists and physicists can take to began to share their knowledge.

Econophysics’ (mathematics) goal is not to over run all the financial managers and create computer systems that know the future. Some economists believe that the econophysics is trying to discover a ‘cookie-cutter’ formula to beat the stock market. This is an unsubstantiated claim that couldn’t be further from the fundamental purpose of econophysics. In his article Can Math Beat Financial Markets?  David Biello clearly outlines the overall purpose of the study of econophysics. Unlike the common presumption, econophysics is not the study of prediction, “No model can consistently predict the future. It can’t possibly be.” Rather, the study of econophysics lies within the field of the examining of risk associated with a given security (stock, bond, commodity). No one or thing can predict the future, consequently, the ‘runner-up’ is what’s the risk linked to the placement of a decision (ie. a financial security entity). As David Biello explains, econophysics is analogous to insurance companies, “they cannot tell you when you are going to die, but they can predict the risk that you will die given the right information.”

Econophysics is a growing field, but the disconnect between the economists and physicists is a worthy point of concern. However, this itself is not enough to stop econophysics dead in it’s tracks. In fact, “there is now a body of respected economists who acknowledge the potential value of ideas and tools taken from other sciences, including physics, and who are receptive to the efforts of physicists. (Econophysics Matter, 1). Thus, the continuation of econophysics is evidently still ‘alive’, nonetheless, it is at a much slower, less respected, pace than it reasonably should be.

Another reason for the lack of growth is current fundamental economic theory principles have yet to be concretely defined, by empirical facts, making the entrance into the field of economics more difficult for the physicist. Through placing the econophysicist at the very beginning of the spectrum of knowledge, it forces them to develop and research financial markets from the their very core, outwards. The forced research of econophysicists from the framework of finance to the outer realms of abstract theory may have helped discovery the ‘un-normally’ distributed returns of the markets, which EMH rests heavily upon. Research from the ground upwards creates a more broad range of discovery, thus furthering the benefits of the study more than would have been previously possible.

Econophysics is worth further consideration and respect in the finance industry. In the Nature article ‘Econophysics Matter’, the author explains “Economics and physics are two disciplines that, contrary to widespread perceptions, have significant common agendas. Shame, then, that the professionals don’t do more to recognize the fact.” Econophysics has already made substantial contributions to the finance industry; from the use of leverage, and to the refutation of the Efficient Market Hypothesis. Within his article “What Has Econophysics Ever Done For Us?” Mark Buchanan outlines eight objective points in support of econophysics. By discussing the already realized contributions Mark portrays a coherent, irrefutable argument for the continuation of this field of study, especially in regards to the unsound practices currently in place, which includes EMH.

There is a considerable number of financial advisors who subscribe to an approach that is unsubstantiated, unlike that of which econophysics rests upon. Econophysics has “…helped to establish empirical facts about financial markets…” (Buchanan, 1) Despite the widely accepted theory, the financial markets’ returns are not normally distributed, consequently refuting the Efficient Market Hypothesis, modern portfolio theory and capital asset pricing model (CPAM) (Franck & Schinckus, 454). The ramifications of the discovery of non-normally distributed markets (gaussian distribution) to the finance industry’s current market processes is substantial. For example, by EMH being false, financial advisors are now responsible and theoretically capable of producing superior returns to those of their peers and towards the overall stock market. EMH being false also increases the competition among advisors to produce higher returns. Mark Buchanan describes this revolutionary finding by stating “Econophysics research has shown, however, that completeness brings with it inherent market instability… a possibility never raised by standard economic analyses.” Following a logical sequence of reasoning, it becomes painfully obvious that standard economic theory was doomed from conception, basing entire theories on nothing but more theoretical assumptions is circular logic that cannot stand up to empirical facts in which econophysics provides the finance industry.

To base econophysics worth solely upon the above points would be ludicrous, nevertheless, enough for the continuation of this revolutionary field of study. Through econophysics we achieve a new look at the, unsubstantiated, widely-accepted finance industry concepts such as the theory of efficient markets. Econophysics has enormous potential, it is here to stay, but economists and physicists both need to set aside their differences, look at the facts and collaborate in producing interdisciplinary journals/meetings in a way that will be beneficial for all parties.

 

“Econophysicists Matter.” Nature.com. Nature Publishing Group, 07 June 2006. Web. 30 Jan. 2015.

Buchanan, Mark. “What Has Econophysics Ever Done For Us?” Nature.com. Nature Publishing Group, 03 June 2013. Web. 30 Jan. 2015.

Jovanovic, Franck, and Christophe Schinckus. “The Emergence Of Econophysics: A New Approach In Modern Financial Theory.” History Of Political Economy 45.3 (2013): 443-474. Business Source Complete. Web. 30 Jan. 2015.

Biello, David. “Can Math Beat Financial Markets?” Scientific American Global RSS. Scientific American, 16 Aug. 2011. Web. 30 Jan. 2015.

“Efficient Market Hypothesis (EMH) Definition | Investopedia.” Investopedia. Investopedia, 18 Nov. 2003. Web. 09 Feb. 2015.

Econophysics and it’s Lamentable Stalling