Two caveats to efficient markets in finance that I’ve just considered, but don’t see mentioned a lot in discussions of bubbles like the one we just experienced, at least as a non-economist:
First: Irrational people are constantly entering the market, often in ways that can’t necessarily be predicted. The idea that people who make bad trades will eventually lose all of their money and be swamped by the better investors is only valid inasmuch as the actors currently participating in the market stay the same. This means that it’s perfectly possible for either swarms of new irrational investors outside the market to temporarily prop up the price of a stock, or for large amounts of insider investors to suddenly *become* irrational because of some environmental change that the rest of the market doesn’t have the ability to account for. Those irrational people might be cycled out, but maybe not before some new irrational traders move in, etc. If this process is predictable, then certain investors might be able to guarantee long-running above-average returns simply by taking advantage of these new investors ritualistically.
Two: Just because what is being done in the stock market is “stock trading” doesn’t mean that the kinds of people who are successful in one region, or socioeconomic climate, or industry are going to be successful in all trading environments. Predicting which companies are going to pay the most dividends has turned out to be a very general problem, partly because analysts have gotten so good at it, but overfitting is still an issue. In the 50s, it was probably important for investors to have a steady hand, be somewhat naturally rational, and maybe quick at mental math. Now, you just have to be a top 0.001% data scientist. The good traders in both groups of stock analysts have to be very intelligent, but there are also probably non-overlapping traits that one group might possess and not the other. I doubt the data scientists Renaissance Technologies has today are as calm under pressure as they’d need to be if they were making trades by hand instead of solving the more abstract problem of building the model that implies arbitrage opportunities.
I think part of the reason that COVID-19 blindsided the market so hard was the effects of #2. The 50s-era stock traders don’t control most of the capital anymore. And I may be underestimating how good they are, but I think most quantitative trading firms were just unable to anticipate an event like COVID-19 because Goldman developed an adaption that said “stop trading based off expert opinion”. That adaption worked to filter out competing firms for a decade, but then it failed this year in a way that seemed bewildering to rationalists, because nobody is old enough to think to make a pandemic-modeling algorithm.
Obviously, if these meta-trends can be predicted, then someone will get good at meta-finance and pre-emptively stock their staff with quants in 1990 and temporarily hire new workers for Q1 2020. The existence of any actor that is completely competent in all variations of finance will eventually solve finance. But if some aspects of them can’t be, then this could be an inherently limiting part of the sectors’ effectiveness.
Two caveats to efficient markets in finance that I’ve just considered, but don’t see mentioned a lot in discussions of bubbles like the one we just experienced, at least as a non-economist:
First: Irrational people are constantly entering the market, often in ways that can’t necessarily be predicted. The idea that people who make bad trades will eventually lose all of their money and be swamped by the better investors is only valid inasmuch as the actors currently participating in the market stay the same. This means that it’s perfectly possible for either swarms of new irrational investors outside the market to temporarily prop up the price of a stock, or for large amounts of insider investors to suddenly *become* irrational because of some environmental change that the rest of the market doesn’t have the ability to account for. Those irrational people might be cycled out, but maybe not before some new irrational traders move in, etc. If this process is predictable, then certain investors might be able to guarantee long-running above-average returns simply by taking advantage of these new investors ritualistically.
Two: Just because what is being done in the stock market is “stock trading” doesn’t mean that the kinds of people who are successful in one region, or socioeconomic climate, or industry are going to be successful in all trading environments. Predicting which companies are going to pay the most dividends has turned out to be a very general problem, partly because analysts have gotten so good at it, but overfitting is still an issue. In the 50s, it was probably important for investors to have a steady hand, be somewhat naturally rational, and maybe quick at mental math. Now, you just have to be a top 0.001% data scientist. The good traders in both groups of stock analysts have to be very intelligent, but there are also probably non-overlapping traits that one group might possess and not the other. I doubt the data scientists Renaissance Technologies has today are as calm under pressure as they’d need to be if they were making trades by hand instead of solving the more abstract problem of building the model that implies arbitrage opportunities.
I think part of the reason that COVID-19 blindsided the market so hard was the effects of #2. The 50s-era stock traders don’t control most of the capital anymore. And I may be underestimating how good they are, but I think most quantitative trading firms were just unable to anticipate an event like COVID-19 because Goldman developed an adaption that said “stop trading based off expert opinion”. That adaption worked to filter out competing firms for a decade, but then it failed this year in a way that seemed bewildering to rationalists, because nobody is old enough to think to make a pandemic-modeling algorithm.
Obviously, if these meta-trends can be predicted, then someone will get good at meta-finance and pre-emptively stock their staff with quants in 1990 and temporarily hire new workers for Q1 2020. The existence of any actor that is completely competent in all variations of finance will eventually solve finance. But if some aspects of them can’t be, then this could be an inherently limiting part of the sectors’ effectiveness.