I wondered whether anyone could help me out. I have been thinking about Arrow’s theorem. Can it be applied to financial assets?
Wikipedia says that:
“In short, the theorem proves that no voting system can be designed that satisfies these three “fairness” criteria:
- If every voter prefers alternative X over alternative Y, then the group prefers X over Y.
- If every voter’s preferences between X and Y remain unchanged, then the group’s preference between X and Y will also remain unchanged (even if voters’ preferences between other pairs like X and Z, Y and Z, or Z and Z’ change).
- There is no “dictator”: no single voter possesses the power to always determine the group’s preference.”
In the financial markets 1. and 3. probably hold. If everyone prefers equities to bonds, then equities will rise and bonds fall; and nobody always determines how the financial markets move. That leaves 2. as the criterion that does not hold. What would this mean?
Imagine that the economic backdrop is bullish and everybody prefers copper to equities and equities to treasuries. Now there is a change, so that everybody prefers treasuries to equities. Copper now falls by more than equities. Isn’t this exactly what we see in the markets every day? The most-preferred asset in a bull phase becomes the least-preferred asset in a bear phase. Is it economic reality driving these changes, or is it the logic of the system?
This is not my field and it could all be rubbish — any ideas out there?