LATTICEWORK OF MENTAL MODELS BY ROBERT G.

HAGSTROM

Since his origin, man has been an embodiment of curiosity; his curiosity has led him to

look for answers to his being, nature, and environment through the discovery and acquisition of

knowledge. This curiosity led to the discovery of science as the study of the physical and natural

world and phenomena, especially by using systematic observation and experiment (Encarta,

2008). In the cause of time, even science as a whole proved to be insufficient to satisfy his

curiosity and craving for knowledge, and as a result was broken into different disciplines and

branches of study that focused on particular specializations with respect to the ideologies of

different schools of curiosity (or thought). After so many years, these branches have been

divided into even more branches as systems evolved and new ideas were adopted; amongst these

new areas of study, finance has evolved as a science that describes the management of money,

banking, credit, investments, and assets (Investopedia, 2008).

As the financial environment has become more sophisticated, new approaches and

models to thinking have also evolved to offer explanations to the complex occurrences in the

financial environment. The main challenges in this area had always been how to comprehend the

mechanism of the markets with the workings of the economy. As we continue to seek

explanations and patterns to the occurrences in our financial environment, more concepts and

models continue to evolve.

Hagstrom’s latticework of mental models attempts to answer some of these questions by

adopting a reverse approach; it does this by explaining the basic concept of finance, economics

and markets through the branches mainly consisting of physics, biology, the social sciences,

psychology, philosophy and literature. Robert Hagstrom’s latticework of mental models takes us
back to this beginning, bringing it all back to a whole by showing how they all relate to the

particular basic concepts in finance. However, in order to totally grasp the concept of the

latticework of mental models, a proper definition of the basic terminology would be appropriate.

What is really meant by the Latticework of Mental Models?

The term Latticework has different interpretations in different fields of study and

professional practice: in the construction industry the Latticework is an open framework made of

strips of metal, wood, or similar material overlapped or overlaid in a regular, usually crisscross

pattern (occasionally latticework has a checkerboard pattern). Latticework is often seen as a

component of porches, decks and gazeboes (Beaulieu, 2008). According to the national science,

it is an ornamental framework consisting of a criss-crossed pattern of strips of building material,

usually wood or metal but can be of any material (National Master, 2007). The two definitions

imply an embodiment of other components or constituent of a structure. This is really the basic

ideology behind Hagstrom’s Latticework which infers an embodiment of varying components of

worldly wisdom. Hagstrom portrays the latticework of mental models as an ancillary of Charles

Munger’s approach to analyzing financial markets and investment decisions.

According to Charles Munger, the latticework of mental models is simply as an

interlocking structure of ideas that is obtained by defining the relationship between the basic

concepts of the all disciplines in answering questions or solving problems that could arise on the

investment environment; linking these disciplines –according to Munger- is embracing worldly

wisdom in its totality. A model can more or less tell you what is going to happen if there are no

shocks and structural changes in an economy.

 Worldly wisdom according to Hagstrom is that solid mental foundation without which

success in the market, or anywhere else is short-lived. However, I would like to say that though

attaining worldly wisdom is beneficial, a more concentrated approach to specific fields gives

room for specialization, and without specialization their can really be no deep emphatic

understanding of the markets.

The latticework of mental models is founded on the big ideas of every discipline. I concur

with the fundamental view that every field of knowledge is founded from the basic principles of

another field, so it would not be totally wrong to say that each one is a fragment of the other with

some fundamental unique similarities or patterns; though these unique similarities cannot be

manipulated to offer direct interpretation to problems in other disciplines, instead its basic

principles are used to develop responses that are applicable to other disciplines and vice versa.

Hagstrom portrays finance and the stock market as a part of the general body of

knowledge, which incorporates psychology, engineering, physics, mathematics, and the

humanities. The field of finance clearly illustrates this assumption; for instance, while there are

the behavioral schools of thought in finance and those that are proponents of the Efficient Market

Hypothesis; through a broader view of the two schools of thought the theory of the Adaptive

Market Hypothesis (AMH) have been propounded.

Kurtay (2007) refers to this approach to investment thinking as trans-

disciplinarily: the conversion of information into knowledge through the mind traveling across

various disciplines and reaching knowledge outside the disciplines. Research emerging from a

trans-disciplinary approach - continues Kurtay - reflects a true integration and synthesis of

knowledge from each discipline rather than a mere compilation of knowledge; it results in truly

new perspectives that are more than the sum of parts.

 Mental Models in Hagstrom’s view mainly refers to the fundamental concepts adopted

from every discipline to guide responses to a set of conditions and random scenarios. In this

book, Hagstrom proposes adopting flexibility in the analysis of investment decisions, and in the

understanding of the markets; he argues that investment decisions founded on narrow sources of

data (restricted to a particular industry) would be inadequate in the assessing all the factors that

affect the decision making process.

According to Kurtay (2007), Unforeseeable uncertainty can only be dealt with if the

decision maker’s response to nature’s moves is not fixed in advance but is itself uncertain. An

uncertain response in this context refers to a response that is flexible or customized to deal with

particular situations. With the pending financial crisis, businesses have adopted new ways of

doing things, with most executives reviewing old policies and introducing new strategy.

One major setback with the trans-disciplinary approach is that it is time consuming and

therefore could be a waste of time when applied to a project or problem that has no correlation

with these basic disciplines. There is a need for the average investor or analyst to view the

market from a broader perspective because it results to a flexible approach towards properly

analyzing investment data and conflicting opportunities.

Lollapalooza effect simply implies that extraordinary rewards are in prospect to those

who are willing to undertake the discovery of combinations between mental models. According

to Rockwood (2004), the lollapalooza effect occurs when several models in the network combine

and are heading in the same direction to produce a given result. In other words, this outcome can

be seen as a synergy of mental models that aim at producing a more pronounced effect to the

decision that is to be made.

 In his book Hagstrom presents a series of models that cover basic areas of knowledge that

play a major role in the worldly wisdom. They are as follows:

Physics

Physics is a complex science that focuses on the study of matter, energy, force, and

motion, and the way they relate to each other (Encarta, 2008). This physical science can also be

credited for extensive theories to how the universe functions. One of the most important

attributes of this physical science – says Hagstrom – is that it seduces us with a sense of certainty

and gives us the comfort of absolute answers. This has led many theorists and analysts in an

inquiry of the basic concepts and principles propounded in this field of study.

Hagstrom attempts to identify the importance of physics and the direct influence of most

of its core principles on the mechanism of the economy. His main focus, however, is on the

impact of one of the most fundamental theories of physics on the stability of the markets and

aggregately on the economy. He illustrates a classical example of combined mental models by

focusing on a theory that forms the foundation for the science.

Sir Isaac Newton – being one of the founding fathers to the advanced physics -

propounded the theory of equilibrium; which was derived from combining the laws of planetary

motion with the observation that a falling mass accelerates at a uniform pace (Rockwood, 2004).

In explaining the basic concept of the laws of equilibrium, Hagstrom establishes a relationship

between the law of equilibrium and economics. Most scholars have termed this new field of

study that presents such a relationship: “Econophysics”.

Econophysics – according to Jurkiewicz & Nowak (2003) - is an approach to quantitative

economics using ideas, models, conceptual and computational methods of statistical physics. In

recent years many of physical theories like theory of turbulence, scaling, random matrix theory
or renormalization group were successfully applied to economy giving a boost to modern

computational techniques of data analysis, risk management, artificial markets, macro-economy,

etc. Econophysics became a regular discipline covering a large spectrum of problems of modern

economy; and one of such problems is the anomaly experienced in the markets.

The theory of equilibrium propounded by Sir Isaac Newton has been used by economists

to explain how the markets are supposed to work. According to Rockwood, 2004: One of the

products of such resolution is the efficient market theory which states that stock prices and

intrinsic values always trade at equilibrium in the market; though this assumption is flawed, it

would not be totally inappropriate to state that stock prices trade at their perceived intrinsic value

(at least in the short run).

He purports that the forces of equilibrium work to maintain a balance between the

demand and supply of a commodity (either in form of stocks, bonds or real goods) in the market.

With respect to business organizations he concurs with Marshall’s opinion that business firms

grow and attain great strength, and afterwards perhaps stagnates and decays; but while this

assumption in (in reality) might appear to be true in some business scenarios, it is flawed on

several grounds:

Firstly, business organization experience a decline in the scale of their operations

mainly as a result of ineffective policies and losses to investment and not as a result of

some force of equilibrium as could be the case with real goods;

Secondly, business organizations are setup as going concerns and such an

assumption of implied stagnancy in future operations or scale goes against the basic

principles of business;
 Finally, while real goods are subject to the forces of demand and the manipulation

of the supply by firms, a business organization is setup to consistently experience growth

as demand increases by diversifying and expanding its product quality and quantity in

other to meet perceived growing demand.

The basic assumptions of market equilibrium are based on the fundamental believe that

investors are rational. This is flawed mainly because the varying risk preferences, returns

expectation, the manner in which information from the market is interpreted, and the

disreputable practices like short selling results to market disequilibrium. Some analysts however

point to the fact that naked shorting, albeit inadvertently, may help markets stay in balance by

allowing the negative sentiment to be reflected in certain stocks' prices (Investopedia 2008), but

that assumption is yet to be authenticated.

A more in-depth explanation would be provided for this later on during this paper.

Biology

In considering the field of biology, the author believes that the mechanism of the

economy and markets can be understood by considering the core theory of evolution. The theory

was developed by Charles Robert Darwin November, 1859. The natural process of evolution –

continues Hagstrom - is one of natural selection, seeing the market as an evolutionary framework

allows us to observe the law of economic selection.

According to Rockwood (2004), Darwin believed that natural selection could produce

variations that had some benefit to a species and its survival. These variations, and their

subsequent benefits to the species, would be passed on to succeeding generations. On the other

hand the law of economic selection proposes flexibility in the adoption of a new strategy that
would offer more profit making opportunity for a business organization. To the regulators, the

law of economic selection offers an avenue to introduce new regulations that would protect

investors and strengthen the markets. In view of the current global financial crisis, most business

organizations have been forced to make changes to their major policies and strategy in a bid to

cut operations and minimize losses. The regulators on the other hand - in view of the crisis that

has been blamed on the unethical sale of subprime mortgages – have introduced regulations to

prevent the occurrence practices in the future; for instance, the Securities and Exchange

Commission – at the peak of the crisis – had issued an emergency order to protect Investors

against Naked Short Selling1; and also relaxed the conditions of the mark to market accounting

system which requires that companies adjust the book value of their assets to its (the asset)

market value at the period.

I believe the theory of economic selection contradicts the fundamental assumption of the

theory of equilibrium which proposed the forces of equilibrium would always act to ensure that

the prices and intrinsic value of stock would always trade at equilibrium. The major flaw with

this assumption is the assumed rationality of investors and market analysts. Peter Bernstein

observed this anomaly in his analysis of dividend yield from 1954 to 2008; Investors in the old

days, says Peter Bernstein, appear to have behaved more rationally than investors in the more

sophisticated and theoretically aware era since 1954. Differing generations of investors appear to

have differing views on how bonds and stocks should behave as the environment changes.

In view of the law of economic selection, Brain Arthur (economist) proposed that

contrary to the implied stability, the world was constantly changing, it was full of upheavals and

1
Naked Short Selling: is the practice of selling a stock short (selling an instrument not
owned by a seller at the time of sale), without first borrowing the shares or ensuring that the
shares can be borrowed as is done in a conventional short sale.
surprises, and it was constantly evolving. After further research by the group at the Santa Fe

Institute (to expand on the Arthur’s observation), they concluded that;

• What happens in an economy is a function of the interactions of a great numbers of

individuals, with the action of each individual influenced by actions of a limited number

of agents.

• The economic system is controlled by the competition and coordination between the

agents of the system.

• The behavior, actions, strategies of the agents, and services consistently adapt to changes

that result from new markets, institutions, behaviors and the likes.

• The economy is in constant change, and operates far from equilibrium.

Hagstrom describes major changes in the system as a feedback loop. A feedback loop refers

to the situation in which the agents form initial expectations or models and act on the basis of

predictions generated by the model; but which constantly undergo changes as the new scenarios

evolve and new conditions are introduced. As the models change, so does the predictability if

the future occurrences.

Arthur defines the economic system as complex, adaptive and evolutionary and as a result

agents in the system compete for survival against the predictive models of other agents, and the

feedback generated result to further changes to the models with other non performing models

abandoned. For instance proponents of this main idea have propounded a new theory to the

characteristics of market known as the adaptive market hypothesis. Adaptive Markets Hypothesis

(AMH) , is based on some well-known principles of evolutionary biology (competition,

mutation, reproduction, and natural selection), (Lo, 2004) ; I argue that the impact of these forces
on financial institutions and market participants determines the efficiency of markets and the

waxing and waning of investment products, businesses, industries, and ultimately institutional

and individual fortunes.

I believe this theory proposing the evolution of models and economic structure is

fundamentally acceptable. As economies grow and new infrastructure and technology is being

introduced outdated or crude methods or ideas are abandoned. This fact was very evident in the

manner in through United States Treasury department redefined the $ 700 billion dollars

approved to bailout financial institutions during the current financial crisis. The treasury claimed

the changes were due to modifications (economic selection) on the perceived impact of the

bailout funds, and in the words of the interim assistant treasury secretary – Neel Kashkari

“strategy evolved as conditions changed”. In summary to the impact of the theory of evolution, I

believe that “a generation (or system) learns from the mistakes of a previous generation, only to

give birth to a new generation that would make new mistakes to be learnt by a successive

generation.

Social Sciences

In this field, Hagstrom defines the mechanism of the market based on the behavior of the

participants in the market. The participants – usually consisting of financial analysts, investors

-in the market, could be analyzed by groups in other to understand their group behavior. Most

social scientists however oppose the relevance of a group analysis of the markets; for instance,

the neoclassical school of thought assume transactions take place in a social vacuum whereby

identities of buyers and sellers, as well as prior history of transactions or social relations, are

largely irrelevant. Markets are by and large seen as “unstructured aggregations of individuals, the

‘buyers’ and ‘sellers’ coming together for only short-lived dyadic exchanges.” (Khan Pyo Lee,
2004). However, there exists no market without exchange and no exchange without interaction.

The social interaction is the necessary condition to the building and the spatio-temporal

organization of a financial market (Schinckus, 2004).

According to Hagstrom, Social scientists adopt the scientific approach as they work to

explain how human beings form collectives, organize themselves and interact, and based on their

findings they develop theories that led to the construction of models that can be used to properly

analyze given data. This approach, however, is flawed on the basis of the unpredictable behavior

of human beings, which is a factor that negatively affects the authenticity of results generated. I

believe that every line of conversation (on ideas and convictions) leverages on the scientific

method. One of the major problems encountered in observation and personal expression, is that

people make a lot of assumptions (hypothesis) based on a limited number of observations, and

deduce faulty conclusions from these untested assumptions.

The impact of economics as a discipline in the social sciences cannot be over

emphasized. It is a field of study that examines how society manages its scarce resources.

Economists therefore try to determine how people make decisions, based on their salary, their

buying and saving habits, and how they allocate their savings. Economists also study how buyers

and sellers of particular goods forecasts the price a good will sell at and what quantities of the

goods will sell at the agreed-upon price. Finally economists analyze issues that affect the

economy as a whole (Rockwood, 2004).

Hagstrom portrays economics as the first discipline to attain a status of separate study in

social science as a result of the early work of Adam Smith - also known as the founder of

economics - on the Wealth of Nations. He is popular for his advocacy of the laissez- faire

capitalist system that discourages government interference in the economy. However, in the wake
of the current global financial crisis such theories have been dismissed as being too risky and

unrealistic; for instance, the government failed to intervene in rescuing the distressed Lehman

brothers Inc, in which the US Treasury eventually admitted it had taken an extremely gutsy

gamble by letting Lehman fail; mainly because of its subsequent impact on global financial

markets with record breaking job losses and 2-4 percent loss in the value of the stock exchanges

in United States, Europe and Asia (New York ,AFP, 2008). Bernstein argues that when financial

markets experience a significant disruption, a systematic approach to risk management requires

policymakers to be preemptive in responding to the macroeconomic implications of incoming

financial market information, and decisive actions may be required to reduce the likelihood of an

adverse feedback loop.

Hagstrom argues that the theory of division of labor had negative social consequences on

the economy which includes a decline of general skills and craftsmanship, perceived

incorporation of women and children into workforce, and the tendency to divide society into

economic classes and opposing interests. I believe these assumptions a partially flawed on the

following grounds; firstly, division of labor promotes efficiency, reduces labor time as a result of

efficiency, develops team spirit of social service, discourages selfishness, fosters easy

organization of work groups and social clubs, and increases time for leisure and social

intercourse (Thompson, 1923).

He portrays political science as a focus on the behavior and impact of government on the

society and how they are created by the people; anthropology which was concerned with the

evolution of man as a species (physical anthropology) and the investigation of the social aspects
of the many different human institutions found both the primitive and contemporary societies

(cultural anthropology). Cultural anthropology gave birth to sociology2.

Hagstrom argues that the market just like nature is in a constant struggle for scarce

resources, and that the process of natural selection in humans would inevitably lead to social,

political and moral progress. I believe this assumption is completely accurate because it assumes

that human beings have a tendency of irrationality; the current financial crisis is an evident result

of this fact. Bernstein (2008) correctly states that Human nature develops odd biases. According

to him, the fundamental stability and growth momentum of the global economic system created a

bulging appetite for risk taking that led investors around the world to gorge on anything that

looked risky. A point came when any trigger would justify ever greater risk taking.

According to Hagstrom, economies and stock markets are adaptive systems implying

their behavior changes as individuals’ constantly interact with one another and with the system

itself. An attribute that is peculiar to these adaptive systems is their formation process; which

refers to how people come together to form complex systems and further organize themselves

into some order. The economist Paul Krugman calls this the theory of self organization which

stipulates that the evolution of cities is a self organizing and self reinforcing system. Hagstrom,

however, draws a relation of this phenomenon to the transformation and adjustment of the

economy mainly as a result of exogenous events (risks) such as oil shocks or military conflicts.

I believe this assumption is not completely accurate because endogenous risk than they

are exogenous risk. Endogenous risk (or events) refers to the risk of shocks that are generated

and amplified within a system; exogenous risk on the other hand refers to shocks that arrive from

outside a system. According to Danielsson & Song Shin (2002), financial markets are subject to

2
Wiki: Sociology is the scientific study of human behavior.
both types of risk. However, the greatest damage is done from risk of the endogenous kind; this

was very evident in the stock market crash of 1987, the Long Term Capital Management crisis of

1998, and the collapse of the dollar against the yen in October 1998. These were all caused by

endogenous risks, and they had more impact on the economy than oil price instability

experienced during the third quarter of 2008.

He further argues that economic cycles are caused by self reinforcing effects which led

to greater construction and manufacturing until investment declines. He purports that such a

decline in investment will subsequently lead to a decline in production which would in turn

result to an increase in investment. What Hagstrom fails to understand however is that when

production declines businesses could liquidate as a result of their inability to meet debt

obligations.

Hagstrom further elaborates on other characteristics of complex adaptive systems which

include the theory of emergent behavior and states that as everyone in a system attempts to

satisfy their needs they ultimately create an emergent structure in the system. He also explores

the theory of criticality – by Per Bak – which states that complex systems composed of millions

of interacting parts could break down not only because of a single catastrophic event but because

of a chain reaction of smaller events which lead ultimately to a large catastrophe.

Hagstrom advocates the theory of collective choice which stipulates that when all the

agents in a system aggregate information in a way that allows everyone in the system to reach a

collective decision such a decision would result to a stable outcome in the system. This is what

Diana Richards chooses to call “mutual knowledge”. I however disagree with this view because

in certain scenarios like the subprime crisis where most business executives where oblivious of

the consequences of their actions, and as a result caught in a crisis that have collectively affected
the financial system. As a result of this, I believe it would not be inappropriate to say that in

some conditions mutual knowledge could actually be disguised mutual ignorance. This is

reinforced by Gustave Le bon in the next chapter.

Psychology

Psychology is the science that studies the workings of the human mind. Its main focus is

to study of the workings of the brain, mostly the parts that deal with cognition and emotion. The

importance of understanding the workings of the brain cannot be overemphasized, studies have

shown that by comparing the amount of blood flow to different parts of the brain before, during,

and after the task, it is possible to detect higher levels of activation in certain regions of the brain,

thus associating the performance of the task with those regions (Andrew Lo, 2005).

Hagstrom explains that through psychology we can understand how stakeholders to the

financial markets think, communicate, experience emotions, process information, and make

investment decisions; through psychology analysts are able to predict the response of investors

to a new regulation, investors (through the help of financial analysts) can understand the

temperament of a company through its financial statements and the prospective options, fund

managers are able to make credible forecasts that guarantee higher returns for their portfolio etc.

Hagstrom focuses on the impact of the cognitive and emotions domains of psychology on

the quality of decisions and direction of the market. This concurs with the opinion of Benjamin

Graham – a successful investor, teacher, writer and industry leader – who implies that the

problem experienced in the market is really as a result poor interpretation of available data from

information (processed data). In his words, Graham states that “the problem of the industry is

speculation per se; speculation has always been a part of the market and always will be”. He
further states that our failure as professionals is the continued inability to distinguish between

investment and speculation.

I believe this opinion is accurate; in the financial markets today there has been an

overdependence on models to interpret and predict the direction of the market, with so much

models created as an aid to speculation, a majority of the analysts today depend on these models

without an attempt to question the authenticity of the data they provide.

Hagstrom, in his opinion, believes that investment decisions based on emotions usually

tend to be faulty because they are irrational. Irrationality in this context referring to decisions that

are based solely on returns irrespective of the risk involved. These types of investors base their

investments decisions on gut feeling and gambles, instead of on a careful analysis of the

opportunity.

The author also illustrates the effect of a group on individual judgment by adopting the

theory of Gustave Le bon (a French sociologist). Le bon observed that in a group individuals

who may be very different from one another in every respect, are transformed into a unified body

with a collective mind that causes members to behave very differently than they would if each

person were acting in isolation. The sociologist observed that the opinion of the group causes

people to sacrifice their individual views. I prefer to refer to this as the “crowd effect syndrome”

which is really a major cause of the pending global financial crisis; most investment banks took

part the subprime mortgage investments knowing full well the risk involved, but they took this

for granted on the guise that since every other investment bank and financial institution was

involved they could get away with it.

Philosophy
 Philosophy is the study of the nature of existence, knowledge, truth, beauty, justice,

validity, mind, and language. According to Quinton (1995), it is "thinking about thinking. He

elaborates further by defining philosophy as rationally critical thinking, of a more or less

systematic kind about the general nature of the world (metaphysics or theory of existence), the

justification of belief (epistemology or theory of knowledge), and the conduct of life (ethics or

theory of value).

Hagstrom revisits the issue of the market as a complex adaptive system. Lee Mcintyre -

a professor of philosophy – carried a study on the complexity theory, and came up with the

following conclusion; firstly, complexity thrives on the fact that we do not have complete

knowledge on some systems, which makes complexity in-eliminable as a result the incapacity to

understand them fully. Secondly, he states that complex systems are not inherently complex but

rather appear so only because of our limited descriptive capacities. However, Mcintyre believes

that the sense of disorder that is a function of the complexity can be eliminated if the system can

be reanalyzed and re-described. I believe this approach would seem appropriate, but it would

cost even more to offer new explanations about the workings of the market in its complexity, in a

hope to do away with its previous accepted principles.

Pragmatism is the aspect of philosophy that defines the truth in statements and rightness

based on their practical outcomes. Pragmatism according to Hagstrom focuses on open minds,

and gleefully invites experimentation. It rejects rigidity and dogma and welcomes new ideas.

Pragmatism is – from my view – a very important attribute to investing. This is partly because it

eliminates principles and ideas that are not practical and adopts those that offer prospective

returns with a past record to prove it. The major flaw is that there is a risk of rejecting new

untested ideas that could offer higher returns on the guise that they do not have a past record of
viability. However, a pragmatist is very conscious of the continued viability of an adopted model,

strategy etc Bill Miller – a very successful portfolio manager – states that models have tendency

to work for a while and then stop working. In such a situation, fund managers are expected to

adopt newer models and discontinue ineffective ones. Kurtay (2004) elaborates on this by stating

that “the impact of changing economic conditions as well as the introduction of new asset

categories on modeling assumptions needs to be monitored continuously, and appropriate

methodologies and techniques should be implemented in response to these developments to keep

the asset allocation as efficient and prudent as possible.

In investing on the markets the portfolio managers have faced two prospective models of

investing: the first-order model focuses on the William dividend discount model that is structured

to meet the criteria for value investment because it determines the real value of securities; the

second-order model however focuses on other measure like low price earnings ratios, low price-

to-book ratio and the likes.

The success experienced by Bill Miller as one of the most successful fund managers is

attributable to the fact that he quickly recognized the difference between first order and second

order models; he had broader approach to sourcing for information on securities that transcended

the field of finance and economics. According to Bill Miller "I often remind our analysts that

100% of the information you have about a company represents the past, and 100% of a stock's

valuation depends on the future."

Literature

The author in the last chapter of the book provides an avenue through which the average

student, investor or analyst can effectively carryout the art of reading. He presents the approach

to reading in stages with motives that are outlined in form of questions, which are as follows:

i. What is the book about as a whole?

ii. What is being said in detail?

iii. Is the book true, in whole or part?

iv. What of it?

While this is important for effective reading, he proposes different types of reading that

vary with the purpose intended. These include;

Elementary reading which is achieved in elementary education; Inspectional reading, is the

form of reading which mainly involves scanning through the book in other to determine if

you are interested in reading the book further; Analytical reading, involves thoroughly going

through the book with the intention of absorbing the content of the book.

PAPER 2: PHYSICS – PRINCIPLE OF EQUILIBRIUM

Physics is an advanced form of natural science that seeks to understand very basic

concepts such as force, energy, mass, and charge (Holzner, 2006). More completely, it is the

general analysis of nature, conducted in order to understand how the world around us and, more

broadly, the universe behaves. Physics as a field of study has always proved to be very relevant

to the field of finance because of its basic concepts and principles that have helped in fostering a
sense of certainty and – in Hagstrom words – given us the comfort of absolute answers. These

concepts and principles are One of the principles that have played such a major role is the law of

equilibrium propounded by Sir Isaac Newton.

Newton’s Law for equilibrium is divided into two forms namely: static equilibrium and

dynamic equilibrium. The law for static equilibrium states that an object at rest will remain at

rest, while an object moving at a constant velocity will continue to move in that fashion until it is

acted upon by an unbalanced, outside force; while the law of dynamic equilibrium states that the

acceleration an object experiences is directly proportional to, and in the same direction as, the net

force acting upon it and is inversely proportional to the object's mass (C. E. Linebarger, Silas

Ellsworth Coleman 1911).

These laws distinct but similar in purpose both have significant roles in some of the basic

principles applied in economics and finance. Economics, says Hagstrom – have turned to the

Newtonian paradigm and the laws of physics. This has led to the development of a field simply

known as Econophysics.

Econophysics - as stated earlier – is the Econophysics –is an approach to quantitative

economy using ideas, models, conceptual and computational methods of statistical physics

(Jurkiewicz & Nowak, 2003). Econophysics became a regular discipline covering a large

spectrum of problems of modern economy; and one of such problems is in the area of

eliminating market anomaly and fostering its stability.

The equilibrium theory of Isaac Newton infers attaining market equilibrium through the

interplay of market forces; for example as with static equilibrium, it emphasizes the effect of the

forces of demand and supply that must collectively function to ensure the market attains stability
by remaining in equilibrium. Alfred Marshal – a pioneer economist – concurs to this view by

arguing that “when demand and supply are in stable equilibrium, any factor that changes or alters

that state of equilibrium would be met by an opposing factor working to restore the previous

state of equilibrium.

The efficient market theory – according to Rockwood (2004) - is an example of such

thinking, since it states that stock prices and their intrinsic values always trade in equilibrium in

the market. Andrew W. Lo (2005) further explains that the theory was established on the notion

that markets fully, accurately, and instantaneously incorporate all available information into

market prices. The advocates to this theory believe the market is composed of rational investors

that possess all the information they need, and can equally interpret such information efficiently.

Louis Bachelier stated that the market, the aggregate speculators, at a given instant can

believe in neither a market rise nor market fall since for each quoted price, their existed as many

buyers as their sellers; which ultimately meant that the market would always be stable since the

forces of demand and supply were uniform. Samuelson – a Nobel Laurent – reinforced this

theory by stating that the market was made up of people who were rational thinkers, hence the

stock prices at any given point in time were a reflection of rational decisions. To further

strengthen the resolution of these advocates of financial market equilibrium, Eugene Fama – in

his doctoral dissertation – asserts that “in the efficient market, a great many smart people ( Fama

called them “rational profit maximizers”) have simultaneous access to all relevant information,

and they aggressively apply that information in a way that causes prices to adjust instantaneously

– thus restoring equilibrium – thus restoring equilibrium before anyone can profit.

Verdict
 I believe the syllogism - of these economists – is not accurate because the premise of

their opinion is faulty. Firstly, these economists supporting the efficient market theory – which

advocates market equilibrium -assume that the market is made up of rational investors.

According to Ariely – Professor of business – “Humans aren’t the perfectly rational beings that

classical economics assumes them to be. No, they’re slyly deceitful and self-contradictory,

subject to subtle forms of mind control. In a study, he once put 6-packs of Coke or plates with six

one-dollar bills into shared refrigerators in college dorms to see if cash itself was a variable in

people’s honesty. The cash was untouched for 72 hours; the Cokes were all lifted. He also found

that simply substituting a token for cash — even a poker chip that will quickly be converted to

cash — encourages more cheating (Leif Bates, 2008).

Studies have shown human decision making does not seem to conform to rationality and

market efficiency but exhibits certain behavioral biases that are clearly counterproductive from

the financial perspective Andrew W. Lo (2005). Agents of the market have varying preferences,

reaction to information, and strategy to investing; while a category focus on the short term

benefits to investing, others are concerned with long term expected returns, and while some

appear to be highly risk averse, others appear to be risk takers. Some of the events in the markets

that portray the erratic behavior of investors – according to Alan Greenspan – include the 1634 to

1636, “tulip mania” spread through Holland, causing the price of tulip bulbs to skyrocket to

ridiculous levels, only to plummet precipitously afterward, creating widespread panic and

enormous financial dislocation in its wake. Other examples include England’s South Sea Bubble

of 1720, the U.S. stock market crashes of October 1929 and October 1987, the Japanese real-

estate bubble of the 1990s, the U.S. technology bubble of 2000, the collapse of Long-Term
Capital Management and other fixed-income relative value hedge funds in 1998, the real-estate

bubble in England and the current global financial crisis.

The theory of efficient markets also assumes that the agents in the market have

simultaneous access to relevant information. This position eliminates the possibility of making

abnormal earnings from information received; but this is not the case with current trend of

prosecution as a result of insider trading violations. According to Hagstrom Bill Miller – a

renowned fund manger- infers that the information from the market in itself is not sufficient to

base an investment decision; which further puts a doubt to the quality of the information in the

market.

In equilibrium – according to William Sharpe – the capital asset prices have adjusted so

that the investor, if he follows rational procedures (primary diversification), is able to attain any

desired point along the capital market line. He may obtain a higher expected return by incurring

additional risk (Sharpe, 1964). However, Dr Sharpe in an early article decried the total validity of

this assumption, because –in his words – “any could game this” implying that the model could be

manipulated by fund managers to appear favorable. This really is as result of the complex nature

of the market which is not totally stable - mostly in recent times.

I believe the principle of equilibrium is very practical but would have a more favorable impact

on commodity markets than it would on the security market characterized by agents that hope to

take advantage of the system to generate returns.

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Lehman_Brothers_fails_plunging_world_economy_into_danger.htm Lehman Brothers fails,

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http://www.c-span.org/Watch/watch.aspx?MediaId=HP-A-10986 HOUSE OVERSIGHT

SUBCMTE. HEARING ON FORECLOSURE PREVENTION Friday, November 14, 2008