Emerging Markets in an Upside Down World: Challenging Perceptions in Asset Allocation and Investment

Chapter 4

Limitations of Economics and Finance Theory

‘… the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.’

Keynes, General Theory, Ch 24, V

The ideas of defunct economists have led to misleading, partial or otherwise inadequate investor understanding. In the next two chapters the intention is to focus on those economic ideas that influence the standard thinking of investors but may lead to sub-optimal practical investment consequences.

1. Investors need to assess how financial markets will behave – it comes as no surprise to market practitioners that inefficiencies, market failures, sub-optimal and ‘irrational’ behaviour, bubbles and crashes exist. What does economics have to say about these, and is it helpful? This is the main focus of this chapter.

2. Investors are interested in assessing risk. So we need to understand what risk is, and this is the focus of Chapter 5.

3. Investors need to appreciate more than market behaviour. They need to understand policymakers, and policymakers need to understand them and be aware of how markets behave. For example, how should we assess sovereign default, devaluation or inflation risks which result from policy decisions? We start to cover that in Chapter 5 with ...