Why Markets Are Inefficient: A Gambling ‘Theory’ of Financial Markets for Practitioners and Theorists

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.

The prologue to this article is available here: http://ssrn.com/abstract=2949001.

Keywords: Rationality, Market Efficiency, Risk, Kelly, Coin Flip, Heuristics, Gambling, Betting, Trading, Algorithmic Trading, PPGS, SAFM, FLOG, Grationality, POPP, SAMM

JEL Classification: B50, C50, C57, D53, G00, G01, G02, G12, G14, G17