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Mandelbrot Suggests A Hunt For Financial Patterns
Phoe6 writes "Wired is carrying an Open Letter of Benoît Mandelbrot, the father of the fractal, to the wizards of Wall Street, calling on them to recognize a pattern in the finantial and economic trends in the world. Mandelbrot says, If we can map the human genome, why can't we map how a man loses his livelihood? If millions can contribute a few cycles of their PCs to the search for a signal from outer space, why can't they join a coordinated search for patterns in financial markets?" I'd like to see a debate between Mandelbrot and Friedrich Hayek.
Considering that Hayek has been dead for over 10 years, I think that debate would definitely be worth seeing.
Mandelbrot watches Pi, has idea...
using either linear algorithmic models or a parrallel neural network approach.
However while most people agree that past performance is indicative of the future nothing can predict what is going to happen. Things such as politics and current events have a huge impact but are not easily factored in to a computer program.
There are many sophisticated solutions to recognising and predicting complex patterns but with the stock market there is an element of trying to predict the lottery.
If the lottery is run properly then every draw should be completely random, any pattern detected in past draws should be about a useful as picking your numbers out of a hat.
Are you familiar with Elliot cycles? Probably not. He came up with an idea like this around a decade ago. (Reading back issues of NewScientist can do wonders for you knowledge like this.) These ideas keep getting thrown around but never come to fruition because at their core they are inaccurate. As simple as that. Whether it's based on power laws, or assumptions about the nature of price spikes (up-up-down-up-up-down), trying to reduce markets to mathematical patterns invariably fails.
8:14 read slashdot /. is the language of nerds.
8:15 restate my assumptions:
1.
2. Everything around us can be represented and understood through discussion threads and trolls.
3. If you graph these numbers, karma emerges.
Therefore: There are karma whores everywhere in nature.
8:17 Press Submit
"And what if we DID map it?"
Well, it'd probably make a really good screensaver...
I lose nothing by running Seti@HOME, and I have nothing (or at least little) to gain. Let's say that my computer is the one that finds the "alien signal" paving way to a real sustainable contact, visits, technology exchange and what have you with an alien civilization. I'd be lucky to end up in a history book.
Similarly, the research groups working on the signal processing, detection, filtering and what have you, will freely share information - again because they have nothing to gain by refraining therefrom.
But financial markets? If my computer can detect that in a few weeks General Electric's shares will plummet - why would I want to give that information away? Would I get a reward from the research group (at a financial institution somewhere most likely) that could (and of course would) benefit from this information?
Would the algorithms even be developed? Why would one group (at Citibank for example) share their information with another group (at GE Capital or whatever)?
There would not be sharing of knowledge. There would not be sharing of results. Simply because the potential gain you have by keeping the information confined is too great.
If you could forecast financial markets reliably on a large scale, imagine how powerful you could become. You could buy the planet.
And this, ladies and gentlemen, is why shit like this won't happen. Not as long as financial markets deal in things that have material value.
If we can map the human genome, why can't we map a man's livelihood? If millions can contribute a few cycles of their PCs to the search for a signal from outer space, why can't they join in a coordinated simulation of Friedrich Hayek?
...finding aliens will have great importance for society. Solving AIDS or cancer or other great medical vices of our time will have great importance for society. But financial markets?
Who'd profit from that? Remember that most of the money made in the stock market is made off the losses of other stock holders - one person's loss is another's gain. If you alone can find the pattern, you profit. If everyone finds the pattern, it has very little value.
Something that made everybody run twice as fast, wouldn't in any real way change sports. The fastest would still be the fastest. Have you truly achieved anything then? I don't see this as a useful cause to dedicate my clock cycles to, do you?
Kjella
Live today, because you never know what tomorrow brings
Let me recap Mandelbrot's point here.
In the April 2003 settlement of postbubble fraud charges, the biggest Wall Street firms agreed to cough up $432.5 million to fund "independent" research. Mandelbrot then makes the distinction between two kinds of research. One is the kind of research where analysts study a publicly traded company, and then give recommendations to buy, sell or hold. The other kind is fundamental economic research.
Mandelbrot then suggests that at least five percent of the settlement money be directed toward fundamental research. He does not say that we should look for a way to predict the markets with absolute certainty - that would be impossible, as many here have redundantly pointed out. (He would probably be insulted to know that so many here think that's what he advocated. He's not stupid, you know.)
He's talking about giving a boost to the kind of fundamental economic research that's already taking place. Stuff like risk management, for example. If you read the article, maybe you noticed that in the beginning he clearly gave examples of what's wrong with our present models in risk management.
Bernstein probably read Mandelbrots essays about exactly the same topic and draw its conclusions about that. It was Mandelbrot, who in 1963 suggested that all statistical analysis done so far yielded just one result: Markets are unpredictable by looking at historical data. He coined the term 'scale invariant' to describe the fact, that without a numbered scale you can't tell what period a random example of stock market data describes.
;)
(Mandelbrot (1963): The variation of certain speculative prices. Mandelbrot (1963): New methods in statistical economics.)
So I guess, Mandelbrot knew already 40 years ago what Bernstein wrote
That financial markets are stochastic is an assumption - with extreme levels of 'deterministic noise' it can appear stochastic - a small difference when specifying an equation to predict a future level can make a massive difference: this is chaotic. Stochastic modelling works OK because of the large levels of noise, most modern finance is built on the assumption errors are Gaussian, a framework formalised in the 60s but assumed even earlier. Sadly today anyone can trot out a Black Scholes thesis, support the group think in academia, and get a PhD from a decent institution (a disease in many disciplines other than economics/finance).
Think of financial markets like the weather - tomorrow is more likely to be the same as today, some minor variance, but saying it is going to be largely similar will mean you're right most of the time: this doesn't help pedict a storm. Likewise tomorrow the stockmarkets will likely be the same as today, but this doesn't help predict a crash. As weather the stock market model can be refined, but in the end it is chaotic and hugely deterministic (many agents looking at each other and others actions).
Many agents looking at each other's actions is important - the market does not exist without agents (buyers/sellers) - it is an endogenous process. A co-operative solution will not work - someone always has to do worse for anyone to do better than the market - the market and the economy is just the sum of the actions of participants, participants cannot move against the market as they, in sum, are the market. Calling on the market to recognise a pattern is folly - a small participant can take advantage of any pattern if discovered, but the market as a whole cannot because if they stop their present action to follow/takeadvantage of/neutralise the pattern they have stopped taking action that creates the pattern.
Patterns in financial markets have long been looked into, a good starting point on current thought, if interested, is technical analysis and elliott-wave theory
The stock market in fact has a wealth multiplying effect, as all financial markets do: the "money" you have in $100 Yahoo shares isn't sitting in a bank account somewhere, but is instead being used by Yahoo to invest in other companies (through stock swaps), is being loaned to companies to make capital investments, is being used as collateral by individuals, etc.
You're wrong in two ways;
1) Money does not sit dormant in a bank account. It gets loaned out or invested by the bank. Banks can lend out (usually in the form of mortgages, overdraughts and credit) or otherwise invest money held in their accounts for up to 90%.
2) Money is only injected into companies like yahoo to actually invest when they issue new stock.
Stock-swaps are basically using monopoly money to buy monopoly money, and aren't captical investments anyway. Post-IPO gains in a stock's price doesn't put money into the corporation's hands.
And you're kind of wrong in a third way too; if I buy $100 of Yahoo stock post-IPO, I'm buying them from some other guy who might be using that money to invest elsewhere.
On the whole, the money that is tied up in the markets (in the form of shares held by investors) isn't doing much "work"; over the long term it's comparable to a savings account.
If your aim is to stimulate the economy, you'd be better off spending money on high risk ventures that don't have as much of a zero-sum nature; e.g. venture capital, small (starter) business loans, junk bonds, etc.
The markets reflect how well the overall economy is doing mostly on account of the fact that people don't throw money into the market if they need their cash to feed hungry mouths. Other than that they only reflect how well a company or a bunch of companies is doing relative to others.
Bottom line: stop talking out of your ass about something you clearly know nothing about.
You said it.
SCO employee? Check out the bounty
(Note: I have degrees in mathematics and finance.) Mandelbrot is not talking about making price predictions in the stock market, e.g. "if the price goes up on Monday, it will go up on Tuesday". As many ./ers have already noticed, any such scheme would be self-defeating: if people began to anticipate a Tuesday price rise, they would buy on Monday, driving the price up a day early -- and erasing the pattern.
For this reason, most financial models assume that stocks follow a kind of stochastic (i.e. random) process called a "martingale", meaning that returns are uncorrelated over time, so you can never beat the market with a strategy like the one above. However, this leaves open the question of which probability distribution the returns follow.
The earliest models, such as the Black-Scholes model for option pricing, assume that stocks follow geometric Brownian motion -- this means that returns follow a normal probability distribution, i.e. the usual bell curve. However, real world markets do not follow a normal distribution: the tails of the distribution are much "fatter", meaning that the Black-Scholes model underestimates the risk of extreme market moves. Therefore, this is a bad risk model, and a company full of Nobel prize winning PhDs, called Long Term Capital Management, followed it off a cliff in the late 90's, nearly bringing down the US financial markets. (For a captivating account of LTCM's rise and fall, check out the book "When Genius Failed".)
This is what Mandelbrot means when he "encourage[s] the study and adoption of more-realistic risk models". We need a better model for the statistical dynamics of markets in order to properly understand (and price) risk -- i.e. to be able to compute accurately the probability that such-and-such price move will happen -- not to make simple-minded stock predictions.
If you're interested in Mandelbrot's own mathematical work on the subject, I'd recommend his book "Fractals and Scaling in Finance". For a great read about the inherent unpredictability of the markets, try the books "A Random Walk Down Wall Street" or "Fooled By Randomness".
Cheers,
IT
Power corrupts. PowerPoint corrupts absolutely.
The outcome would be that financial markets would still exist but that the predictable pattern would disappear.
Financial markets aren't just about short term speculation. The purpose of, say, a stock or bond market is to match people wishing to lend money and bear risk to those wishing to borrow.
Contrary to some posters opinions this is not a zero sum game. The borrowers use the money to invest in business and produce a return - a return which wouldn't have been possible if there had been no way for the borrower to find that source of finance.
If financial markets work perfectly then the prices within them represent the 'best guess' of the value of the underlying asset. The result is that investors' money goes in to the best investments - those which will give the best returns. Imagine if dot-com stocks had been correctly priced. How many fewer doomed companies would have been able to float or raise additional capital? That money could have been diverted to investments which, instead, produced good returns and helped the economy to grow.
If market returns could be predicted (so that buying stocks became risk free) then investing in stocks would be just like investing in, say, treasury bonds. A market would still exist because the underlying need - matching borrowers to lenders - still exists. Perfect predictability will never happen, though - company values depend on unpredictable factors out there in the real economy. Think of future consumer tastes, harvests, weather, the outcome of sporting events and terrorist attacks. In fact, a perfectly functioning market that takes all available information in to account would probably not contain any (exploitable) patterns. It should be obvious why: if prices correctly take in to account all available information then only new information can cause them to change (given constant interest rates and risk premia). Without having had this information in advance you couldn't have predicted the change - and if you had the information then this contradicts the assumption that it's new.
Some forms of basic research should be publicly funded because they have no inherent reward. For example, Research on Black Holes.
Research on stock markets, is a whole different kettle of fish. He who achieves a superior understanding of the operation of markets may choose the nature and amount of his reward. This type of research will be amply funded by the private sector, and it is. Every major bank employs a large staff of PhD's in Finance, Economics, Physics, and Math, to research these issues. They are handsomly paid and very well supported. (one of these banks is the biggest APL shop around).
Dr. Mandelbrodt's request that the SEC should use public money to fund research on markets shows that he does not understand the distinction between these types of research. The SEC should not use money as he proposed. The SEC should use money to help it discharge its fundamental duty, which is the protection of investors.
A couple of prominent recent examples are high pressure sales of investments to soldiers and selling non-tradeable real estate trust shares to retirees [the Wall Street journal Story was much better, but is on their subscription only site that I cannot hack]. When the SEC figures out how to spot these types of scams before the newspapers, which are reactive organisms too, then they can start worrying about esoterica like the underlying mathmatcal basis of markets. Of course, by then chickens will have lips.
In the land of the blind, the one-eyed man is king.