When Markets Turn

The EconomistThe Economist ran a special report on the future of finance last week. One item caught my eye – When Markets Turn: A Parable of How Modern Finance Can Go Wrong. The story looks back at the collapse of the Long-Term Capital Management in 1998. The article puts some of the lessons of that funds collapse to the current collapse of the credit markets.

They identify the theory put forth by Mr. Soros on “reflexivity.” Once people come to believe that an economic theory is true, they over invest in that economic theory. “Once people come to believe that house prices never fall, they will buy too much property—and house prices will fall. When they believe that shares always do well in the long run, they will buy too many shares—and the market will do badly for years.”

Relexivity makes financial markets more dangerous than the casinos. “The numbers on a roulette wheel never change, but markets offer no guarantee that yesterday’s odds will be the same tomorrow.”