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Algorithmic Investors on Wallstreet
eldavojohn writes "Recently, setting up prediction markets that people play was the big thing to guess the future. But is there a chance that computers will replace investors? From the article: 'Quantitative investment managers use a model to identify sets of characteristics for their investments. Computing power is now relatively cheap. Obviously, computing power can access data almost instantaneously and simultaneously. Asset classes and financial instruments within those asset classes can then be screened and investments are selected. They reflect the manager's views.'"
What they're talking about is arbitrage and trading, not investing. Their trades are designed to be in the short-term. Sometimes, very short-term - within a second.
We all know when it comes to predicting markets they will both be beaten by a gang of monkeys and a dartboard.
The key comment was:
More importantly, the models provide insight into market inefficiencies to be applied rapidly across asset classes and the vast number of financial instruments within those asset classes. Whole markets can be analysed daily for buy and sell indications at an individual instrument level. This enables portfolios to contain a larger number of instruments and reduce risk through greater diversification of the portfolio.
As inefficiencies are identified (such as when the return / risk ratio is not correct) provides an opportunity to increase returns by taking advantage of them. Of course, as more people use models the inefficiencies will be corrected quicker, leaving less opportunities to exploit. In effect, the market fixes itself. This, of course, is nothing new - markets adjust to new technologies all the time and eventually the opportunities they offered disappear; for example when the telegraph first came out no doubt someone discovered they could buy an item at one place for less then the same item where they were and arbitrage the prices - but as more people started doing that the spread disappeared.
I'm a consultant - I convert gibberish into cash-flow.
This would true except for the fact that our market is NOT a 'zero-sum' system. Just because someone makes money does not mean someone else has to lose money. Investors are investing in these companies for their own benefit, but what does the company do with this money? They use it to expand their business, fund things, etcetera. This creates wealth -- when a company produces a product, that is wealth, in terms of stock. Nobody lost money in the production of that product. In fact, others probably gained wealth as well, as that company may have bought materials and parts from other companies, with them making a profit off of selling their created wealth. Just because there is a static amount of physical cash in this system does not mean that the amount of wealth is static.
So when a person is born, using models and best decision practices, the system(s) can predict what the earning potential (investment wise) for the new born is. Compiled with analysis of their genes, the life expetancy and health of the new born can also be determined. Then, the system(s) can decide if the new born will be a drain on society or not. Given enough computing power, data models, and algorithms, mankind's future will soon be predictable.
There are no loopholes. It's either legal or it's not.
Let's be honest here, the "human factor" was what made some huge enterprises possible. Because some humans believed in something the "numbers" alone didn't predict. Do you think Google would have found an investor in its early days?
Investment by numbers is by definition a rather conservative way to invest. In other words, put your money where there already is money. Risk investment is usually something done by visionaries, not by bean counters. And yes, 9 out of 10 times the idea bombs. But the one that works pays hundredfold.
We used to have a Bill of Rights. Now, with the rights gone, all we have left is the bill.
If that happens, and if all the investitors has access to such software, my bet is that the whole point of investing on market will flop
Not at all. Every major player in the market already uses some kind of computer modelling, for risk analysis, pricing, arbitrage or whatever. There is basically a perpetual arms race as different investors come up with new strategies or better ways of modelling a particular part of the market. The result is a more efficient market - fewer things are mispriced.
The sad thing about capitalism is that there's always a fixed amount of money on the market, so to win somebody else has to loose.
You clearly just don't understand how markets work. The purpose of any investment market is to bring together lenders of money (investors) with borrowers of money (companies, governments etc). It is not a zero-sum game. If use of computer modelling allows investors to make better decisions, in the end it benefits everyone.
A friend of mine tried writing his own auto-investment code to see if he could actually make a living at it. His plan was to dedicate a computer to doing nothing but scanning the market and making investments for him. Well, he's not doing that today, and he's probably one of the most intellegent people I know. I also rememeber a concern that, if everybody used automated investing, the market would become highly sensitive to change (or...unstable) as you'd run into situation where most, if not all, of the algorythms out there would react the same way to certain market changes.
Still, it's intriguing isn't it? I mean, one of the things I use computer programming for is to learn how things work. I look at it this way; a computer is rock-stupid, but it does exactly what you tell it to do. So, if I could write a code to do market analysis, I'd be learning the intricacies of how to do it along the way. Sure, most invesment sites have tools for you, but there is value in learning the underlying mechanisms.
Seems the best approach would be to write such a program to simply do the analysis, then you make the final commit to buy or sell. You'll have a good idea how to interpret what you get back because you told it what to do in the first place and you should be able to spot errors/weaknesses in your strategy. It could be downright symbiotic.
A goal is a dream with a deadline
Investing in the entire market, since 1927, has returned on average of about 10% per year. That's a handsome return! This is the beauty of index investing, which you described. The layperson can easily purchase index funds and sit back and relax. This is a great alternative to the higher cost managed funds which mostly do not beat the market. With an indexed approach it is impossible to underperform the market, because you're buying the market.
Actually, it does help the company that releases the stock. IPOs can raise a lot of money for a company, which they can use to make more money. When the company becomes large and profitable, you get dividends, which benefit the person owning the stock. It works for both people.
Ewige Blumenkraft.
what no one has heard of Long Term Capitol Managment? Wasn't that their schtick too? The stock market can be reduced to a formula? Didn't they almost collapse the entire US economy!!! Nope, sorry...i'm not buying it.
Not really - they started out with arbitraging the slight price differences in bonds, knowing they could make money as the prices converged. They eventually went into other areas as they got more money; and the small differences required huge positions so they were highly leveraged - when an external crises (Russian default) caused a hiccup in the markets they faced a liquidity crises - in short they ran out of money to pay investors moving to other investments. Had they simply sold off their investments the banks feared a greater drop in values which would seriously hurt them - so they, with some prodding, stepped in to bailout LTCM (I guess 3.5 b$ in losses is better than going under for a bank) and protect themselves from a worsening crises. Which shows the old adage is true - if you can't pay back $100 you have a problem; if you can't pay back $100million the bank has a problem.
IAR, the bond market eventually converged again - but LTCM lacked the cash to ride out the intervening divergence. Sort of like what happened to Orange County (who was neither non-liquid nor bankrupt) - had they stayed in their positions they would have made money.
The market has always been about fundamentals over the long term (10yrs+) and emotions over the short term. This is just a way for money managers to abdicate responsibility for poor performance. "But the software said it should go up..."
No, the software, as I read the article, is not about predicting prices (which is a loser's game anyway) but about arbitraging differences in prices to make money; by discovering them before someone else - like LTCM. The problem, of course, is that the difference in prices is often so small that it takes lots of money to make a decent profit, which means being highly leveraged and thus exposed to sudden market moves.
I'm a consultant - I convert gibberish into cash-flow.
Because they are still growing, the losers are those who grow slower than inflation.
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First, there are patterns. You are right that those patterns have a limited capacity to absorb trading and that anyone who finds a pattern would do well to keep it a secret. The EMH (Efficient Markets Hypothesis) is best lampooned by the following old joke. Two economists are walking down the sidewalk when one of them spots a $100 bill in the grass. The first economist starts to pick up the $100 when the second economist tells him, "Don't bother, if it were a real $100 bill, someone would have already taken it." Moreover, EMH makes predictions about the statistical distribution of price movements and the volume of trading that are empirically false.
Second, the price dynamics are not entirely caused by exogenous factors. Investors, speculators, the media, and government officials do watch the prices. People make buy and sell judgments without any fundamental basis such a stock being "expensive" just because the stock is $300/share (never mind understanding the relationships between price per share and capitalization). Humans also have instinctual beliefs in patterns such as trends or momentum that are self-fulfilling. If enough traders believe in trends or momentum, they will trade in a way that creates trends.
The profitable patterns do exist (and so do a large number of profitless pseudopatterns). People with a very sound understanding of both market psychology and statistics can and do succeed.
Two wrongs don't make a right, but three lefts do.
I'd much rather have 4% of the global economy's worth than 100% of my current net worth.
The global economy literally means a friggin big amount of money. Explain to me how any country, company or individual that grows slower than the global average is not a loser in this game.
So if a $10^12 country grows only by 3% a year, it must be a loser compared to all the $10^9 countries that manage a 15% growth ?
I have a friend who worked in the hedge fund game for a number of years. He's a brilliant mathematician, and worked on the models they used to inform their trading. The group he worked with was quite successful, and make a heck of a lot of money.
One of his most interesting comments: "The model can inform your decisions, but you have to know when to NOT trust the model." Another of his comments on a completely different talk: "Mathematical models are never perfect, but they can be useful."
The trading system can be modeled, but you can never capture all the true complexity of the real world. If you leave the model to do it's thing, if I know how it's going to act, I can game the system. If the world changes in a way that the model builders did not predict, then the system will also act inappropriately.
I can't imagine ever getting rid of all the traders out there, though I imagine expert systems will become more 'expert' as time goes on.
Second, hedge fund managers rarely execute trades themselves. They hire traders to do that, apparently you didn't bother reading the article you linked to.
I know, you're linking to a NYTimes article (which you didn't bother citing in your directly quoted 2nd sentence).
"Trolls they were, but filled with the evil will of their master: a fell race..." -- J.R.R. Tolkien on Olog-hai
(Pet-peeve alert.) From your link:
"Vegas cheats come in all shapes and sizes: hardcore mechanics who devise gadgets to manipulate slots and mathematical geniuses who count cards in blackjack."
Aaarrrggghh! Card-counting is not cheating! It is using your brain to make decisions. I know, in this day and age, brain-use is rare enough to be considered cheating, but it is not. It astounds me how often I still see this association in the media.
For that matter, one needn't be a genius to do it, either. Two points off for the History Channel.
To amplify your point, one reason academics might be willing to reveal a technique even if it actually works, is because it may well require a tremendous amount of capital to make a significant profit without a high probability of going broke first. Expectations (average returns) are based on the law of large numbers, and not terribly useful unless you have some large numbers ($$$) to play with.