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Shaky Assumptions

Summary:
All models by necessity distort reality in one way or another.  A sculptor, when modelling in stone or clay, does not try to clone Nature; he highlights some things, ignores others, idealizes or abstracts some more, to achieve an effect. Likewise a scientist must necessarily pick and choose among various aspects of reality to incorporate into a model.  An economist makes assumptions about how markets work, how businesses operate, how people make financial decisions.  Any one of these assumptions, considered alone, is absurd.  There is a rich vein of jokes about economists and their assumptions.  Take the old one about the engineer, the physicist, and the economist. They find themselves shipwrecked on a desert island with nothing to eat but a can of beans.  How to get at them?  The engineer proposes breaking the can open with a rock.  The physicist suggests heating the can in the sun, until it bursts.  The economist’s approach: “First, assume we have a can opener. . . .” The assumptions of orthodox financial theory are at least as absurd, if viewed in isolation.  Consider a few: 1) Assumption: People are rational and aim only to get rich.  . . . .  2) Assumption: All investors are alike.  . . . .  3) Assumption: Price change is practically continuous.  . . . .  4) Assumption: Price changes follow a Brownian motion. Benoit B.

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All models by necessity distort reality in one way or another.  A sculptor, when modelling in stone or clay, does not try to clone Nature; he highlights some things, ignores others, idealizes or abstracts some more, to achieve an effect. Likewise a scientist must necessarily pick and choose among various aspects of reality to incorporate into a model.  An economist makes assumptions about how markets work, how businesses operate, how people make financial decisions.  Any one of these assumptions, considered alone, is absurd.  There is a rich vein of jokes about economists and their assumptions.  Take the old one about the engineer, the physicist, and the economist. They find themselves shipwrecked on a desert island with nothing to eat but a can of beans.  How to get at them?  The engineer proposes breaking the can open with a rock.  The physicist suggests heating the can in the sun, until it bursts.  The economist’s approach: “First, assume we have a can opener. . . .”

The assumptions of orthodox financial theory are at least as absurd, if viewed in isolation.  Consider a few:

1) Assumption: People are rational and aim only to get rich.  . . . . 

2) Assumption: All investors are alike.  . . . . 

3) Assumption: Price change is practically continuous.  . . . . 

4) Assumption: Price changes follow a Brownian motion.

Benoit B. Mandelbrot 

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