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The Fallacy of Perfect Knowledge, by Victor Niederhoffer

Perfect Knowledge of the state of the market is not possible. While no great departure from the actual facts of life is involved in assuming this knowledge on the part of dealers when we are considering the course of business in Lombard street, or in a wholesale Produce Market, it would be an altogether unreasonable assumption to make when we are examining the causes that govern the supply of labour in any of the lower grades of industry. ... There may be a good deal of wayward and impulsive actions, sordid and noble motives may mingle their threads together. -- Alfred Marshall, Principles of Economics

One of the more common fallacies in performing market calculations or any others is the assumption of perfect knowledge. Here are some examples of where it comes up.

The bearish Fed signal. Naive commentators with an axe like those who write the Heard in the Street column are often guilty of this. "Okay, we know that the Fed is about to stop increasing the Funds Rate. What's the move in the stock market between the time that they last increased a Federal Funds rate, and the time that they reduced the rate. Well, I calculated it, and ha , ha, the stock market actually declines during that time. So if you're waiting for the Fed to decrease that rate, then don't. Ha, ha. I'm bearish."

The problem is of course that we don't have perfect knowledge of when they're going to end. Indeed there's an extraordinarily active Federal Funds market where depending on the slightest twist of a Governor's attempt to advance his political career, or use us as Guinea Pigs, billions are made and lost, and the implied probability of a rise at a given meeting is calculated to the fourth degree. Also, relevant is that the Fed generally reduces a rate after a stock market decrease. So if you assume perfect knowledge of what the Fed does you're also assuming perfect knowledge of what the stock market did during that period. Also, of course wrong, is the assumption that you can get the exact proper dating vis a vis time "just" before the announcement or time "just" after the announcement. With any event that has a macroscopic momentum like Fed tightenings and easings, there are only going to be a very small number of changes in direction and the variability is going to be so great that you'll always be able to come up with something bearish or bullish depending on how you choose the survival dates, like from the time of the fourth increase to the 10th, or what have you. (The problem of small numbers and the difficulty of predicting when death will occur is one of the reasons survival statistics are so good for studying markets, and why the hazard rate is so difficult to estimate in the game of life and markets.)

"Okay, we know that company x is going to report down earnings next year. How much can we make by shorting it with this perfect knowledge. And, ha, ha, the economy or company x has already announced a shortfall." Or "We've had a bull market now for three years without any 6% decline from a previous top to a bottom within a three-month period. What is the expected market move the next time that there is such a decrease.  Ha ha, it's bearish."

We'll have to leave this version of the fallacy and a hundred others now to do some play and kid work but I refer you to An Introduction to Austrian Economics for a nice discussion of the philosophical problems of assuming perfect knowledge in a landscape filled with uncertainty. "Vast numbers of interacting individuals try to make the best use of all available means of want satisfaction... "




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