Atomic bombs, the Depression, and equilibrium

E quilibrium asset pricing models typically have been tested by comparing the& predictions with historical data, and then asking whether theory and historical data resemble each other enough to justify believing the theory. Comparing prediction with data is the usual method for deciding whether a theory is valid, and financial researchers have not questioned the merits of this procedure for equilibrium models. In the physical sciences, drawing conclusions about the future from historical data (that is, the results of experiments that have already been done) is possible because we believe that laws of nature that held in the past will hold in the future. This assumption is less plausible in the social sciences. Human behavior is influenced by the theories believed in and used. Continuity with history is not to be expected where a theory itself affects the beliefs on which its predictions are based, as with asset pricing theories. This article argues that, because the development of sophisticated financial theories alters behavior, testing models with data from before the models were developed does not provide an adequate test. A theory that did not predict behavior adequately before the theory’s promulgation may come to predict behavior later. Thus, conclusive rejection or acceptance of an asset pricing theory cannot be based on historical data. The emergence of a new asset pricing theory has two effects. One is that the new theory affects investor behavior and changes it. The other is that academics test it with historical data, information predating the theory. Unfortunately, a theory that did not hold before the promulgation of an argument that people should act in certain ways may hold after the argument is widely accepted. Only after circulation of the theory may there be “sufficient” investors aware that they should act in certain ways for them to eliminate (or essentially eliminate) behavior inconsistent with this theory. Testing the correctness of a theory by seeking evidence of its use before its promulgation would appear strange to researchers in other fields. For instance, there is much known about the logical implications of nuclear reactions. It is known it is possible to build a nuclear bomb and that rational military behavior is to use nuclear weapons against enemy concentrations. A rather elementary implication of modern military theory is that the Normandy Invasion could not have occurred because the Germans could have destroyed the invading forces with a few atomic bombs. Knowing this was the rational response, the Allied commanders would never have attempted the invasion. No historian or military theorist would dream of rejecting modem theories about warfare because nuclear weapons were not used when theory indicates they should have been in World War 11. The atomic bomb is recognized to be a modern and rather complex technology. No one would expect to observe its use, or the consequences of its use or threat of use, prior to its invention. Modern portfolio theory is a similarly complex invention. Why treat its introduction any differently? Let us apply these simple concepts to two