FT Alphaville » Soros – There is a fundamental market misconception (it says so in my book)

Free exchange | Economist.com

Risk is inherent in financial markets. The outcome of many variables can not be perfectly anticipated. The current portfolio models do not, and never have been, intended to enable hedging of every potential outcome. Most are equilibrium models, which means they rely on a set of assumptions that rarely hold in the market. That does not diminish their value. Economic and financial models can be thought of as a map. If a map included every detail in the geography (trees, country roads, etc.) it would be intractable, rendering it useless. Maps do give you a sense of scale and how variables relate. This facilitates your journey, but does not eliminate unforeseen diversions and the potential for accidents.

Finance is a brain for matching labour to capital, for allowing savers and borrowers to defer consumption or bring it forward, for enabling people to share, and trade, risks. The smarter the system is, the better it will do that. A poorly functioning system will back wasteful schemes and shun worthy ones, trap people in the present, heap risk on them and slow economic growth. This puts finance in a dilemma. A sophisticated and innovative financial system is susceptible to destructive booms; but a simple, tightly regulated one will condemn an economy to grow slowly.