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.'"

Comments

Late reporting

[Shoten]

This is nothing new, and it's not even something that's restricted to the world of money managers. It's being used by individual investors now, and has been for years; it's called "technical investing". The definitions of combinations of factors (market cap, financials, etc.) are called 'screens', and are a common source of discussion on forums like those found on The Motley Fool. There's software for sale, priced for individual investors, and there are websites that will even allow you to save your screens to use periodically, looking for new possible stocks to buy into (or to check and be sure that your existing portfolio matches the parameters you want).

Replace investors?

[Aladrin]

Wow, great summary... The computers wouldn't be replacing investors, but 'investment advisors'... That's a whole different rung on the ladder. If they replaced the investors, there'd be no money and the stock market would die.

As for replacing the advisors... Even the article tells you that isn't going to happen. "They reflect the manager's views." Oh... So if there's no manager, there's no view... and the computer does nothing. So you can't drop the advisor.

This is simply another tool. It's not going to change much. My father will still complain bitterly when his portfolio loses money, and complain a little less when he's almost back to where he's started... again. And again.

The fact is... If everyone made money, the stock market would be an impossible thing. Some people will lose while some will gain. No magic piece of software is going to change that.

Re:Replace investors?

[Eivind]

The fact is... If everyone made money, the stock market would be an impossible thing. Some people will lose while some will gain.

That's a pretty fundamental misunderstanding.

If that was true -- if the stock-market was a zero-sum game where the only way to win was to have someone else lose the same amount, then there'd be no point in playing it. Your average return would be zero.

Luckily that is not the case for investments. It *is* the case for speculation (for example day-trading) but that's something else.

When you buy $1000 worth of oh, say, Arendal Fossekompani. You are buying a certain small part of a company. The company, as most companies, try to turn a profit. On the average, they manage that. Some companies make a loss and (if they stay like that) eventually go bankrupt. But the sum total of the profits (or losses) of all companies is hugely positive.

Now, your $1000 part of the company made say $100 of profits this year. They can do two things with this money. Either they divide their profit up and give it to the owners (that's the ones holding the stock), in which case you'd get $100 cash as dividend.

Or they can invest the money, for example use this years profit to improve the powerplant so that it'll produce more power next year. In this case you still own a certain part of the company, but it's a larger, more valuable company. (your piece should now be worth on the order of $1100, but market-forces can change this in either direction) The stock market is not a zero-sum game with no profits. It's a game where the profits are, over time, equal to the average profit of the companies you invest in.

This is trading not investing.

[Anonymous Coward]

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.

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.

LTCM anyone?

[dtd201]

The use of computers models to predict what to buy has been around for some time. The absolute belief in these models caused Long Term Capital Management to go under in 1998 ( see When Genius failed ). I also highly recommend reading Fooled by randomness

the stock market collapse in 1987

[Anonymous Coward]

back in 1987 when automated selling by computers was blamed for making the collapse worse

The most popular explanation for the 1987 crash was selling by program traders. Program trading is the use of computers to engage in arbitrage and portfolio insurance strategies. Through the 1970s and early 1980s, computers were becoming more important on Wall Street. They allowed instantaneous execution of orders to buy or sell large batches of stocks and futures. After the crash, many blamed program trading strategies for blindly selling stocks as markets fell, exacerbating the decline. Some economists theorized the speculative boom leading up to October was caused by program trading, while others argued that the crash was a return to normalcy. Either way, program trading ended up taking the majority of the blame in the public eye for the 1987 stock market crash.

http://en.wikipedia.org/wiki/Black_Monday_(1987)

Re:Market News Writing Computers Also

[k2enemy]

Mainly because the people who do this are are super secret. They don't want anyone to know how or what they are doing because the field is so competitive. It's the equivalent of an algorithm arms race.

They are not as secretive about their methods as you might imagine.

As noted by earlier posters computers are not used to "pick stocks", but to construct portfolios with desirable characteristics, find arbitrage opportunities, etc. I can give a little insight into the first. I'll gloss over a lot and use language somewhat loosely, so please don't jump if you know your finance :)

There is a tradeoff in the market between risk and return. You can construct a portfolio with a very high expected return, but it will involve a lot of risk. Alternatively, you could have portfolio with very little risk, but low expected returns. The trick is to get the highest expected return with the lowest expected risk. Here is where mathematical models run on a computer can help. The most famous and the one everybody knows about is the CAPM (capital asset pricing model). There is a lot of debate in academia over this model, but it is still useful in practical ways.

Last year I attended a lecture and had a discussion with Bob Litterman, the director of quantitative resources at Goldman Sachs. He oversees several billion dollars worth of investments and does so quite successfully. One thing he stressed was that all of the tools they use are publicly available in the form of academic literature that their competition tends to ignore. For example, they use a modified CAPM that allows an investor to incorporate their "views" about certain stocks or sectors into the portfolio problem (this is the somewhat famous Black-Litterman model). Generating these views is still a human endeavor, but then the computers generate the portfolios that accurately represent these views and that have high expected returns with low risk.