Algorithmic Investors on Wallstreet 249
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.'"
Late reporting (Score:5, Informative)
Replace investors? (Score:5, Informative)
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.
LTCM anyone? (Score:5, Informative)
the stock market collapse in 1987 (Score:5, Informative)
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) [wikipedia.org]
Re:Replace investors? (Score:5, Informative)
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.
Re:Market News Writing Computers Also (Score:5, Informative)
The price of a stock is determined by external factors, and the key into being a good investor is access to information: who sued who, what is the union planing, what product is the competition developing etc. So to replace humans with algorithms, you must make them as intelligent as humans in the basic task of finding and understanding information. AI is ages away from this stage, and when/if we will finally have such powerful AI, the stock exchange will be our last concern.
Re:Not illegal (Score:4, Informative)
Re:Market News Writing Computers Also (Score:2, Informative)
These guys [predict.com] are supposed to be really good, but notice how little information you can find on their site. The company was started by one of the guys who mathmatically beat roulette (something else everyone thought was impossible at the time).
Re:Market News Writing Computers Also (Score:5, Informative)
This is equivalent to saying that he "mathematically beat the tossing of a coin" i.e. the statement makes no sense.
Re:Market News Writing Computers Also (Score:3, Informative)
They are not just picking stocks.
They are being used to do things like:
Incidentally the article is pretty useless: it does not actually have very much specific content, does it?
Re:Market News Writing Computers Also (Score:2, Informative)
You must get out a little too much if you haven't seen this [historychannel.com]
Scroll down a little to where it says "Beat the Wheel". They did, in fact, mathmatically beat roulette. Here's the blurb from The History Channel, for those too lazy to click...
Re:Price, Pattern, and Profit (Score:2, Informative)
However, most people agree that publicly available information will be absorbed by the market and eat available profit from that information. The key point of dispute is how quickly this information will be absorbed. So having a program to mull through the flood of information quickly to help capitalize on it is not too hard to believe. Particularly when the guidelines for this program are being revised and set constantly.
Another form of efficient markets is one where you can also make money off of non-public information. Insider trading of course is illegal, but accurate and the in-depth analysis generated off the public information can hold value as well before this analysis is revealed or independently completed by the market.
Re:Comments from a friend in the business (Score:2, Informative)
Re:Market News Writing Computers Also (Score:5, Informative)
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 [wikipedia.org] (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.
Re:Price, Pattern, and Profit (Score:5, Informative)
I've never believed in the EMH, but I'm going to try to defend it anyway.
I've heard that joke many times, and it always seems to me like a false analogy. The EMH doesn't deny the possibility of luck; it denies the possibility of systematically beating a competitive market. The patch of grass is not a competitive market, and finding $100 there by luck is not beating it systematically. In other words, there are fundamental differences between equity markets and patches of grass. For example, shares of the grass are not being bought and sold, therefore information about the existence of the $100 is not being incorporated into prices, which is a fundamental assumption underlying the EMH.
A better analogy would be the following. Assume the existence of a patch of grass upon which a given amount of money falls according to some pattern. Assume also that there is a mature, well-developed industry to predict when the money falls. Assume also that the industry is competitive; ie, when one person takes the money from the grass, it's no longer there for another to take. Assume also that there is some monetary cost to visit the patch of grass and determine if there's any money there. Given all those assumptions, at some point, the grass would cease yielding abnormal returns--in other words, the cost of visiting the grass would equal the average amount found there, given the best available algorithm for determining how much money will be there.
The EMH people would probably respond as follows. Granted, humans believe in patterns which can become self-fulfilling prophecies. Thus, they create a pattern. However other, more sophisticated traders are also aware of the pattern ("momentum") and will place trades that destroy the pattern. For example, if I (as an investor) recognize momentum then it would benefit me to buy shares at the beginning of momentum and sell short at the end, before the bubble bursts. If I do this profitably, then I (and other, similar investors) will control an increasing share of the money being invested, and "momentum" will no longer occur. Note that this pattern-destroying mechanism can occur with any pattern that could be recognized, including self-fulfilling prophecies of naive investors, and including momentum.
...Nevertheless, EMH aside, there are trends which can be identified. One example is the NASDAQ from 1997-2000, which is a particularly striking incidence of momentum. That trend persisted even though there was frank discussion by experts months beforehand that the NASDAQ was certainly in a tremendous bubble. The fact that momentum persisted for years despite publically available pronouncements by all experts that there was momentum, is difficult to reconcile with the EMH, since the EMH asserts that any such trend would automatically disappear.
I believe there's a fatal flaw with the EMH. I believe the EMH rests upon a number of assumptions, one of which is false. But this post is already long enough...
Crash of 87, and arbitrage in general. (Score:3, Informative)
Another friend was a quant for a while around 1990. He and some coworkers found a few sets of patterns in the market that they were able to arbitrage - it makes you a pile of money for a short time, until the market adjusts to it (that's *how* efficient markets work - people find inefficiencies and exploit them, and the first people to find them can make money if they get back out again before everybody else stomps them.) Having faster computers means you can find and grab smaller inefficiencies and make smaller chunks of money off them sooner, leaving fewer big inefficiencies around.
Of course, that doesn't let you predict whether or when Bush or bin Laden is going to pop up and say "booga-booga!" and jack the oil price or increase US government borrowing even more radically than predicted; you have to be an insider to get that, though it does help to keep a range of models around to predict the effects.