Leading Financial Modeling Expert: Adam Smith Was Wrong About the “Invisible Hand”

One of the leaders of the new science of financial modeling – Rama Cont – points out that Adam Smith was wrong about the “Invisible Hand”.

Specifically, investors in financial markets rationally pursuing individual profit can produce outcomes that are bad for almost everyone.

As an article in City Journal notes:

Simple forecasts can also be mistaken if they fail to account for the actions of market participants themselves: investor strategies can influence prices, which in turn influence future strategies in a feedback loop that can cause considerable instability. Cont recalls the severe stock-market crash of October 1987, which seemed to strike out of the blue, since nothing significant was happening in the real economy. Subsequent research, though, blamed the crash in part on a new investment strategy, “portfolio insurance,” which a large number of fund managers had simultaneously adopted. Based on the famous Black-Scholes options-pricing model, this strategy recommended that fund managers reduce their risks by automatically selling shares whenever their values fell. But the approach didn’t take into account what would happen if many investors followed it simultaneously: a massive sell-off that could send the market plummeting. The 1987 crash was thus not provoked by events in the real economy but by a supposedly smart risk-management strategy—and the current downturn, of course, also derives at least partly from a global craze for a seemingly foolproof financial innovation…

Investors in financial markets rationally pursuing individual profit, then, can produce outcomes that are globally negative. Doesn’t that contradict classical economic theory? “Both theory and empirical facts do tend to show that, on the financial markets, the Invisible Hand does not always lead to welfare-improving general outcomes,” Cont replies.

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  • Adam Smith was talking about voluntary markets of buying and selling, lending and borrowing.Adam Smith was not talking about a monetary system that is based on the legalization of a public-private cartel currency of which the money supply is a rigged game. "Elastic Currency."We as Americans and the many countries of the world rejected Adam Smiths' Invisible Hand for the Heavy Hand many years ago.I guess that is why we find ourselves in this mess. Thank you Rama Cont for you incredible foresight and expertise. Blaming Adam Smith for our current situation is a lot like Alan Greenspan not seeing the bubble comming and Ben Bernanake doing his best cheerleading in front of Congress and 60 Minutes to get us to believe all is okay as they give away the family farm so that we can grow up subjects on the land our forefathers conquered.These three people are either blinded because they are making money hand over fist, or they are waging a war from the inside without firing a shot.

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  • I find that talk about financial theories hysterically funny in today's market. When it is common knowledge that Goldman/Sachs type investment houses control, manipulate or rig daily market action by executing 80% of market transactions. The only theory that counts is actually the mood of the trading guru on a particular day.

  • Whenever I see attacks on free markets, they often seem to make the mistake of ignoring the role of information and adaptation in markets. After all, these are the real strengths that markets hinge on. While 1987 was a mistake, nobody ever said that markets never make mistakes. What Smith said was that over time free markets will benefit the majority of us in the long run. We did learn from 1987. Right now we're just finding new mistakes to learn from.