Why Markets are Inefficient: A Gambling "Theory" of Financial Markets For Practitioners and Theorists

TL;DR

This paper introduces the SAFM theory, viewing financial markets through the lens of an enlightened gambler, to explain market inefficiencies, bubbles, crashes, and exceptional investor returns.

Contribution

It proposes a novel, quantitative framework combining gambling theory, human decision making, and strategic problem solving to better understand market behavior.

Findings

Explains market anomalies and inefficiencies.

Accounts for bubbles and crashes.

Provides a basis for predictions in financial markets.

Abstract

The purpose of this article is to propose a new "theory," the Strategic Analysis of Financial Markets (SAFM) theory, that explains the operation of financial markets using the analytical perspective of an enlightened gambler. The gambler understands that all opportunities for superior performance arise from suboptimal decisions by humans, but understands also that knowledge of human decision making alone is not enough to understand market behavior --- one must still model how those decisions lead to market prices. Thus are there three parts to the model: gambling theory, human decision making, and strategic problem solving. A new theory is necessary because at this writing in 2017, there is no theory of financial markets acceptable to both practitioners and theorists. Theorists' efficient market theory, for example, cannot explain bubbles and crashes nor the exceptional returns of famous investors and speculators such as Warren Buffett and George Soros. At the same time, a new theory must be sufficiently quantitative, explain market "anomalies" and provide predictions in order to satisfy theorists. It is hoped that the SAFM framework will meet these requirements.