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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.
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.
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.
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.
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 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.