Epistemology of finance

Last updated

Epistemology of finance is a broad field of study that aims at providing a conceptual framework(s) for the interpretation of mathematical models in finance as well as the study of their possible limitations, in order to determine the epistemological standards according to which financial theory should be assessed against any associated empirical reality. [1] [2] A key problem is to what extent the combination of self-reference and adaption (reflexivity) undermine the stability, uniqueness, and usefulness of predictive models in finance and economics.

Contents

Within applied financial disciplines (which subsume financial economics, quantitative, and statistical finance) a single common assumption is pervasive; namely, that capital markets, being social systems, adhere sufficiently to epistemic norms. It has been argued that the use of incorrect epistemological assumptions is pervasive in financial economics and economics. [3] These assumed epistemic norms carry with them a priori the necessity of unique, well-defined causal chains that can be meaningfully extracted from data. [4] Both heterodox and mainstream economics retain the view that causality remains relevant as a formalism and that models remain sufficiently stable and unique (including under self-reference) and for this reason typically characterize empirical finance as science. [5] [6]

The alternative 'reflexive' view dates back to the 'Oedipus effect' of Popper, in control theory as the study of second-order cybernetics and also features in economics with Kauffman's Eigenform of markets. [7] [8] [9] MacKenzie noted that the study of economics does more than simply describe, but rather shapes and changes the conditions of the economy, and society more broadly. [10] [11] While George Soros is commonly acknowledged as an ardent supporter of the reflexivity paradigm, [12] Nobel laureates Herbert Simon and Franco Modigliani demonstrated an interest in and caution relating to reflexivity. [13] Unsurprisingly, both Simon and Modigliani had a negative view on rational expectations. [14] A third laureate - Robert Schiller - recently emphasised the importance of the study of reflexivity. [15] That the implications of reflexivity have yet to be adequately assimilated in policy intervention, financial regulation or investments could, in part, explain why financial crises are often inherent and unavoidable within a positive framing of economics. [4]

Subjects covered include the study of complexity and complexity theory, financial crisis as well as the epistemology of financial reporting. [16] [17]

It is closely related to philosophy and economics, financial market efficiency, rational expectation theory and the study of causality.

See also

Related Research Articles

Epistemology is the branch of philosophy concerned with knowledge. Epistemologists study the nature, origin, and scope of knowledge, epistemic justification, the rationality of belief, and various related issues. Debates in contemporary epistemology are generally clustered around four core areas:

An economic bubble is a period when current asset prices greatly exceed their intrinsic valuation, being the valuation that the underlying long-term fundamentals justify. Bubbles can be caused by overly optimistic projections about the scale and sustainability of growth, and/or by the belief that intrinsic valuation is no longer relevant when making an investment. They have appeared in most asset classes, including equities, commodities, real estate, and even esoteric assets. Bubbles usually form as a result of either excess liquidity in markets, and/or changed investor psychology. Large multi-asset bubbles, are attributed to central banking liquidity.

Regulation is the management of complex systems according to a set of rules and trends. In systems theory, these types of rules exist in various fields of biology and society, but the term has slightly different meanings according to context. For example:

<span class="mw-page-title-main">Efficient-market hypothesis</span> Economic theory that asset prices fully reflect all available information

The efficient-market hypothesis (EMH) is a hypothesis in financial economics that states that asset prices reflect all available information. A direct implication is that it is impossible to "beat the market" consistently on a risk-adjusted basis since market prices should only react to new information.

Behavioral economics is the study of the psychological, cognitive, emotional, cultural and social factors involved in the decisions of individuals or institutions, and how these decisions deviate from those implied by classical economic theory.

Econophysics is a non-orthodox interdisciplinary research field, applying theories and methods originally developed by physicists in order to solve problems in economics, usually those including uncertainty or stochastic processes and nonlinear dynamics. Some of its application to the study of financial markets has also been termed statistical finance referring to its roots in statistical physics. Econophysics is closely related to social physics.

Performativity is the concept that language can function as a form of social action and have the effect of change. The concept has multiple applications in diverse fields such as anthropology, social and cultural geography, economics, gender studies, law, linguistics, performance studies, history, management studies and philosophy.

Philosophy and economics studies topics such as public economics, behavioural economics, rationality, justice, history of economic thought, rational choice, the appraisal of economic outcomes, institutions and processes, the status of highly idealized economic models, the ontology of economic phenomena and the possibilities of acquiring knowledge of them.

Experimental philosophy is an emerging field of philosophical inquiry that makes use of empirical data—often gathered through surveys which probe the intuitions of ordinary people—in order to inform research on philosophical questions. This use of empirical data is widely seen as opposed to a philosophical methodology that relies mainly on a priori justification, sometimes called "armchair" philosophy, by experimental philosophers. Experimental philosophy initially began by focusing on philosophical questions related to intentional action, the putative conflict between free will and determinism, and causal vs. descriptive theories of linguistic reference. However, experimental philosophy has continued to expand to new areas of research.

A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults. Financial crises directly result in a loss of paper wealth but do not necessarily result in significant changes in the real economy.

Metaepistemology is the branch of epistemology and metaphilosophy that studies the underlying assumptions made in debates in epistemology, including those concerning the existence and authority of epistemic facts and reasons, the nature and aim of epistemology, and the methodology of epistemology.

The Lange model is a neoclassical economic model for a hypothetical socialist economy based on public ownership of the means of production and a trial-and-error approach to determining output targets and achieving economic equilibrium and Pareto efficiency. In this model, the state owns non-labor factors of production, and markets allocate final goods and consumer goods. The Lange model states that if all production is performed by a public body such as the state, and there is a functioning price mechanism, this economy will be Pareto-efficient, like a hypothetical market economy under perfect competition. Unlike models of capitalism, the Lange model is based on direct allocation, by directing enterprise managers to set price equal to marginal cost in order to achieve Pareto efficiency. By contrast, in a capitalist economy, private owners seek to maximize profits, while competitive pressures are relied on to indirectly lower the price, this discourages production with high marginal cost and encourages economies of scale.

In epistemology, and more specifically, the sociology of knowledge, reflexivity refers to circular relationships between cause and effect, especially as embedded in human belief structures. A reflexive relationship is multi-directional when the causes and the effects affect the reflexive agent in a layered or complex sociological relationship. The complexity of this relationship can be furthered when epistemology includes religion.

Epistemology or theory of knowledge is the branch of philosophy concerned with the nature and scope (limitations) of knowledge. It addresses the questions "What is knowledge?", "How is knowledge acquired?", "What do people know?", "How do we know what we know?", and "Why do we know what we know?". Much of the debate in this field has focused on analyzing the nature of knowledge and how it relates to similar notions such as truth, belief, and justification. It also deals with the means of production of knowledge, as well as skepticism about different knowledge claims.

Feminist epistemology is an examination of epistemology from a feminist standpoint.

In finance, momentum is the empirically observed tendency for rising asset prices or securities return to rise further, and falling prices to keep falling. For instance, it was shown that stocks with strong past performance continue to outperform stocks with poor past performance in the next period with an average excess return of about 1% per month. Momentum signals have been used by financial analysts in their buy and sell recommendations.

There have been many criticisms of econometrics' usefulness as a discipline and perceived widespread methodological shortcomings in econometric modelling practices.

<span class="mw-page-title-main">Chen Long (finance)</span>

Chen Long currently serves as the director of Luohan Academy, the think tank of Alibaba. Before this, he was the chief strategy officer of Ant Financial Group since 2014. Chen received his Ph.D. in Finance from University of Toronto, and was a tenured professor at Olin Business School, Washington University in St. Louis. After returning to China in 2010, Chen took the position of the Associate Dean of Cheung Kong Graduate School of Business (CKGSB), Professor of Finance.

<span class="mw-page-title-main">Decolonization of knowledge</span> Process of undoing colonial influences on knowledge

Decolonization of knowledge is a concept advanced in decolonial scholarship that critiques the perceived hegemony of Western knowledge systems. It seeks to construct and legitimize other knowledge systems by exploring alternative epistemologies, ontologies and methodologies. It is also an intellectual project that aims to "disinfect" academic activities that are believed to have little connection with the objective pursuit of knowledge and truth. The presumption is that if curricula, theories, and knowledge are colonized, it means they have been partly influenced by political, economic, social and cultural considerations. The decolonial knowledge perspective covers a wide variety of subjects including philosophy, science, history of science, and other fundamental categories in social science.

Masudul Alam Choudhury is a Bangladeshi-Canadian economist and International Chair in Islamic Economics and Finance at the Faculty of Economics, Trisakti University in Jakarta, Indonesia.

References

  1. ↑ Xavier De Scheemaekere (2009). "The epistemology of modern finance". The Journal of Philosophical Economics. pp. 99–120.
  2. ↑ Lehmann-Waffenschmidt, Marco; Sandri, Serena (2007). Recursivity and Self-Referentiality of Economic Theories and Their Implications for Bounded Rational Actors (Report). Dresden Discussion Paper Series in Economics.
  3. ↑ Lawson, Tony (2013). "Soros' Theory of Reflexivity: a critical comment". Revue de philosophie économique. 14 (1): 29–48. doi:10.3917/rpec.141.0029. ISSN   1376-0971.
  4. 1 2 Polakow, Daniel A.; Gebbie, Tim; Flint, Emlyn (2023). "Epistemic Limits of Empirical Finance: Causal Reductionism and Self-Reference". SSRN Electronic Journal. arXiv: 2311.16570 . doi:10.2139/ssrn.4646664. ISSN   1556-5068.
  5. ↑ Shaikh, Anwar (2013). "On the role of reflexivity in economic analysis". Journal of Economic Methodology. 20 (4): 439–445. doi:10.1080/1350178X.2013.859414. ISSN   1350-178X.
  6. ↑ Lopez de Prado, Marcos (2015). "The Future of Empirical Finance". SSRN Electronic Journal. doi:10.2139/ssrn.2609734. ISSN   1556-5068.
  7. ↑ Gardiner, Patrick; Popper, Karl R. (1959). "The Poverty of Historicism". The Philosophical Quarterly. 9 (35): 172. doi:10.2307/2216437.
  8. ↑ Kauffman, Louis (2009). "Reflexivity and Eigenform: The Shape of Process" (PDF).
  9. ↑ von Foerster, Heinz (2003), "On Constructing a Reality", Understanding Understanding, New York, NY: Springer New York, pp. 211–227, doi:10.1007/0-387-21722-3_8, ISBN   978-0-387-95392-2 , retrieved 2024-04-03
  10. ↑ MacKenzie, Donald (2006). An Engine, Not a Camera: How Financial Models Shape Markets. The MIT Press. doi:10.7551/mitpress/9780262134606.001.0001. ISBN   978-0-262-27880-5.
  11. ↑ Klaes, Matthias (2009). "Do economists make markets? On the performativity of economics, edited by Donald MacKenzie, Fabian Muniesa, and Lucia Siu. Princeton University Press, 2007, 371 pages". Economics and Philosophy. 25 (3): 389–397. doi:10.1017/S0266267109990332. ISSN   0266-2671.
  12. ↑ Soros, George (2013). "Fallibility, reflexivity, and the human uncertainty principle". Journal of Economic Methodology. 20 (4): 309–329. doi:10.1080/1350178X.2013.859415. ISSN   1350-178X.
  13. ↑ Henshel, Richard L. (1993). "Do self-fulfilling prophecies improve or degrade predictive accuracy? How sociology and economics can disagree and both be right". The Journal of Socio-Economics. 22 (2): 85–104. doi:10.1016/1053-5357(93)90017-F.
  14. ↑ Hands, D. Wade (2014). "Introduction to symposium on 'reflexivity and economics: George Soros's theory of reflexivity and the methodology of economic science'". Journal of Economic Methodology. 20 (4): 303–308. doi:10.1080/1350178X.2013.859411. ISSN   1350-178X.
  15. ↑ Kovarsky, Paul (January 2019). "Robert J. Shiller on Bubbles, Reflexivity, and Narrative Economics". CFA Institute.
  16. ↑ Lipshaw, Jeffrey M. (2010). "The epistemology of financial crisis: complexity, causation, law and judgement" (PDF). Southern California Interdisciplinary Law Journal. 19. Southern California Interdisciplinary Law Journal: 299.
  17. ↑ Napier, Christopher J. (2002). "Reflections of the epistemology of financial reporting". University of Southampton.

Further reading

This page is based on this Wikipedia article
Text is available under the CC BY-SA 4.0 license; additional terms may apply.
Images, videos and audio are available under their respective licenses.