Theory+Practice Introduction Random Walk? Unlikely events Impossible events Finance-Ideology Financial practice Econophysics Behavioral Finance	xx Introduction Paper is patient. You can write or draw anything on it. Have a close look at those images above. The frame with rotating hammers, by the way, is a so called 'perpetuum mobile'. But there are many more examples on this site. Here we will concentrate on the statements and expectations of 'modern financial theory', which were taken for granted by the financial industry and their institutions and which lead to the still ongoing crisis of the financial markets and the world economy. This crisis will eventually cost the tax payers billions of Euros. xxRandom Walk? The so called 'random walk' is still the dominating model of finance theory. Price movements of stocks are thought of as being random events, which cannot be predicted by any means, are mutually independent and approximately normally distributed. If this was a scientific theory and not just a belief, it should be consistent and not in contrast to experience. A science has to found its statements on rational argument and these statements must be testable. Benoit Mandelbrot is known to many people for his book:'The fractal geometry of nature',(1982), one of the classical works of chaos theory. In his recent publication: 'Fractals and finance'(2005), he has collected many examples which throw doubt on the scientific foundations of the 'random walk' model of financial markets. xxUnlikely events Mandelbrot investigated the daily index movements of the American Dow Jones Industrial Average for the time from 1916 until 2003. He found, that extreme market movements were much more frequent than expectable according to finance theory, which is based on the assumption of a 'random walk'. According to this theory movements of more than 3.4% would be expected to occur on only 58 days within the whole period from 1916 to 2003. However, they were observed on 1001 days. Movements of more than 4.5% should occur on only 6 days, but they occurred on 366 days. Market movements in excess of 7% should occur only once in 300.000 years, but during the 20th century alone they occurred 48 times. xxImpossible events That the events described above were so unexpectedly frequent is sufficient evidence that the theory cannot hold, and it renders risk calculations of bank managers entirely worthless if based on this theory. Sometimes market movements are so strong that according to theory they would be close to impossible. This happened on October 19, in 1987, when the Dow lost 29% of its value. The probability of this event: once in 10 to the power of 50 trading days. To put that into perspective you should consider that the age of our universe since the big bang, was calculated to be less than 10 to the power of 12 days. In August 1998, during the financial crisis in Asia and Russia, the index lost strongly three times in that month (-3,5%, -4,4% and -6,8%). The expected frequency for this to happen is once in 500 billion times. In July 2002 following the burst of the dot.com speculative bubble there were three heavy losses within seven trading days. The probability for such a cluster of events is once in 4 trillion times. The paragraphs above give just a few examples. Interested readers should contact the site www.misbehaviorofmarkets.com. The erraneous assumptions are not confined to American markets. The writer of these lines has found comparable errors of finance theory in recent years for the German stock index DAX and for the Swiss stock index SMI. Details can be found in Verluste, on the 'Publications' site. Similar failures of finance theory can be observed in the currency markets and not just for less important minor currencies but for currency pairs of the major economic powers: US-$/Euro, US-$/Yen und Euro/Yen, the daily trading volume of which amounts to several trillions of US-Dollars. xx Finance-Ideology All those catastrophic failures of finance theory did not suffice to fit 'a beautiful theory to some ugly facts' and as would be only consequent, to build a completely new one based on solid argument. But nothing of that kind really happened. The only conclusion remaining is that 'financial science' just is not a true science in its literal meaning. It seems that in 'financial science' ideas and beliefs own a higher rank and count more than facts, which contradicts scientific priciples, but is rather typical of ideologies or maybe theologies. The sad consequence of this failure was that financial institutions were not prepared to weather the strong market movements following the mortgage crisis. Losses were stronger than before and they were global, involving stock markets, currency markets and commodities all across the world at the same time. The preliminary result is that world wide assets worth 2 trillions of Euros have gone up in smoke. xx Financial-Practice Bankers are businessmen and unlike university professors they are not responsible to a scientific community, which has settled on mainstream ideas, but to their employers and to their customers. Bank employees maybe and should be pragmatic. They are free to discard an idea that proved wrong and there is more than enough reason to do this with respect to finance theory. They cannot argue that information was missing. All data have been present and accessible to the public. Bankers are thought to be specialists in financial data. They not only could have known but should have known what really happened in the financial markets, their very domain. What will bank customers think if they discover that they left their assets to the virtue of to a bunch of hopelessly overpaid ignorants. THE ECONOMIST, a British weekly finance magazine has a clear opinion of bank managers' abilities: 'most of them are useless' stated in the issue for 12th-19th Oct, 2009. xx Econophysics This expression was coined by above mentioned Benoit Mandelbrot for a new science direction in the world of finance. The expression 'physics' is intended to raise the idea of an exact science. In principle market movements could be investigated using wave theory, a sub discipline of mechanics which represents the core of classical physics. Indeed, the chaotic dynamics of a damped and driven pendulum, a model system of chaos research, resembles the dynamics of financial market movements as was shown in a book by the writer of these lines Finanzmarktanalyse - Neue Ansätze aus der Chaosforschung, (Uhlig, 1999), Verlage: Vahlen, Helbing + Lichtenhahn. Those who are interested in econophysics are referred to a site of the University of Fribourg, Switzerland: www.unifr.ch/econophysics/ At the University of Ulm, Germany, econophysics is a study subject for bachelor and master studies. Lessons on econophysics are also held at the universities of Mainz and Paderborn, both in Germany. xx Behavioral Finance Criticism of finance theory comes not only from representatives of the natural sciences, like Benoit Mandelbrot. Daniel Kahneman and Amos Tversky, two researchers on economic theory were able to demonstrate that one of the basic assumptions of financial theory, namely that market participants behaved rationally, would not hold. Indeed market participants behaved instinctively wrong, that is to their disadvantage, by holding losing investments for too long time and selling winning investments too quickly. If they just lost on an investment they raised their bets instead of lowering them. There are many more examples of contradictions to theory. The new discipline that Kahneman and Tversky established and their new research approach is now called 'Behavioral Finance'. The aim of this research is to learn more on motivation and behaviour of market participants. It is now considered a sub discipliene of empirical social studies. Meanwhile it is even taught at the economics sections of universities. In Germany the Behavioral Finance Group der Uni Mannheim, has published a number of papers on this subject.