Mr Popper’s Predictions

In My Experience

In my experience whenever you hear someone saying "in my experience" you're about to get an earful of incoherent nonsense justified by the observer's single perspective. It's nearly always dangerous nonsense, justified by specific examples taken from a single snapshot in time.

Well, in my experience, personal observations are typified by overconfidence, colored by hindsight bias and impervious to evidence suggesting that they're wrong. They're flung about with gay abandon, but have as much in common with objective truth as a report from an analyst.  The future is unknowable, anyone who claims special knowledge is either lying or mad. And possibly both.

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The Wisdom of Internet Crowds

Crowds in the Clouds

We’ve already seen signs that internet data can be used for various sorts of prediction. Using Google trend data allows nowcasting of employment trends and the spread of disease (see Nowcasting with Google), Twitter may predict stockmarket movements (Twits, Butter and the Super Bowl Effect) and social media predicts investor sentiment (Noise, Sentiment and StockTwits). Reports suggest that there are already fund managers out there exploiting these ideas.

The question remains whether these sources of information are really reliable or whether we’re seeing data mining biases. The more data you have the more probable it is that you can find a correlation between any two variables, proving little other than having a lot of computing power makes work for idle processors. Not all data is equal, though, and some results suggest that the wisdom or crowds is alive and well in the internet clouds.

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Perpetual Novelty, Santa Fe Style

Learnings from Science

By the late 1980's there was a growing recognition that the existing understanding of financial systems was flawed. Not only did markets not behave as the economic theories predicted but they often exhibited behaviour that didn't seem to have any pattern or cause at all.

In response to this a number of economists began looking at some of the research emerging from physics, biology and computer science in the area of complex adaptive systems and this led, in 1987, to a group of economists and scientists getting together at the Santa Fe Institute. The program of work that came out of this seminal event is still unfolding today, but suggests why academics and traders have had such different views on markets: one set lives in the real world, and the other doesn't.  Wanna hazard a guess as to which is which?

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Trading at the Speed of Light

Time is Money

Special relativity doesn’t generally figure high on the agenda of your average trader. Or even your far from average trader, come to that. For most of us, for most of all of time, the speed of light hasn’t ever really figured as an important investment constraint.

However, this is finance and time is money. Quite literally, it seems, as the arms race between the high frequency terminators of the automated trading industry reaches the limits of the known universe. Welcome to where arbitrage meets Einstein. And wins.

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Exit the Walras, followed by Equilibrium

Blinkered

As we saw in Economics and Psychology: The Divorce, the two queenly social sciences long ago parted ways. What we haven’t yet seen is quite what the economists did next, when they abandoned the idea that people had any part to play in economic behaviour.

To do this they chose to follow a path predetermined for them by physicists, which would have been all very well were it not for the fact that the bit of physics they choose to use turned out to be incomplete. Unfortunately, by cloistering themselves away from new research for nearly a century, this new reality was missed and by the time they emerged from their bunkers economics wasn’t so much wrong as irrelevant.

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Investing at the Edge of Reality

Relief from the Bizarre

Mostly we expect scientists to make the world a more understandable place – or at least a more comfortable one. After all, science has helped us move from a state in which we prayed to invisible deities for deliverance from natural disasters to one in which we rely on functionally illiterate politicians to direct relief operations. So, perhaps prayer isn’t entirely irrational…

Unfortunately, as we’ve dug deeper into the mysteries of the multiverse, increasingly we’ve been forced to face the fact that reality is more bizarre than we can possibly imagine and that our senses offer us only a limited window on the world. Oddly, though, it also hints as to why we make investing mistakes.

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Quantum Consciousness is Market Uncertainty

Reality's an Illusion

However odd or downright contradictory we may find financial markets they’re absolutely nothing compared to the bizarre nature of nature itself, which at the sub-microscopic level doesn’t so much defy the application of logic as positively thumb its nose at it. The world of quantum physics is, it seems, quite literally unimaginable.

Yet there’s an implication in the physics of the infinitesimal that has profound implications for everything, not the least of which are the random meanderings of investment securities. The science suggests that there is no objective state of reality outside the confines of our own heads. We are, it seems, the ghosts in our own machines.

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Monte Carlo Simulation or Nuclear Bust

Escape from Berlin

It's 13th July 1938 and an elderly lady of Jewish extraction is boarding a train in Berlin for the Dutch border, barely escaping the grasp of the Nazi authorities. In one of the great switchback points in history the onrushing locomotive of destiny has found itself diverted down a path that will lead, circuitously, to the end of the Second World War, the triumph of the great liberal democracies and the rise of quantitative financial modelling.

Her name is Lise Meitner and now, as we leave her travelling her lonely path to exile in Sweden, she has just 10 marks in her purse. And the key to the atomic bomb in her head.

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Maxwell’s Demon Investor

Self-Organising Wardrobes

In the long-term we’ll all be dead because, in the long-term, there is no escape from the iron hand of thermodynamics which tells us that every system moves from a state of order to one of disorder. It’s a bit like your wardrobe spontaneously re-organising itself. Only when it’s finished you can’t actually find anything in it any more. Neat but bloody useless.

The measurement of order in a system is known as entropy and the idea that entropy always increases is bound up with the idea that energy ultimately moves from a useful and usable state to one in which it’s unusable and useless. And this is as true of stockmarkets as any other system – not even the perfect demon can outperform the markets other than by luck unless they can also escape the laws of physics. Entropy rules – OK?

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Metaphors of Mind and Money

Theories of Mind

The question of how psychologists come up with their theories of how the mind works is one that’s long troubled philosophers. Now this might not seem like a very serious concern, especially to those of us more worried about whether our stocks are going up or down, but this is misleading: how our minds work is part and parcel of how financial systems operate and our theories about this process are important in developing sensible approaches to safe and profitable investment.

Unfortunately psychologists and cognitive scientists who study such things are as likely to suffer from the pain of the availability heuristic as anyone else. The general approach to theory of mind that is now most commonly used is simply based the latest set of tools available to the researchers, who view the mind as a computer. It has ever been thus because we need metaphors to think about things and without metaphors we have nowhere to start from. This brings with it a long legacy of hard to remove but wrong ideas about financial systems.

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Physics Risk Isn’t Market Uncertainty

Physics Envy

The idea that economics should be modelled on the concepts of physics has been prevalent for the best part of a century. It’s a deliciously engaging idea, that the steadfast and unbending rules of science should be the template for the queen of the social sciences. The only trouble is that in economics human beings are part of the system and don’t tend to behave as economists would wish them to.

On the other hand the ideas generated by analogies between physics and economics have generated a whole bunch of truly great economic ideas and are the basis of the whole of microeconomics. Although it’s tempting to argue that these ideas don’t truly make sense it’s actually quite hard to make this accusation stick. Economics and physics are connected – only just not quite the way economists like to imagine.

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Econophysics, Consciousness and Cosmic Karma

The Return of Homo economicus

The failures of efficient market theories notwithstanding, the great problem for behavioural finance is its inability to offer useful predictions about the future direction of the stockmarket. One of the reactions to this has been the expansion of economics into so-called econophysics – the development of models of stockmarkets based on the fundamental concepts of physics.

What’s rarely clear in discussions of econophysics, which often look and feel like behavioural finance models, is that they generally rely on the fundamental assumption of humans as rational agents. Underlying econophysics is our old friend, Homo economicus. Only humans aren’t rational and they aren’t simply particles: we have consciousness and we’re bloody determined to misuse it in any way we see fit.

Bachelier, Forgotten Hero

The interaction of physics and economics has a long history, reaching back to the sixteenth century with Daniel Bernoulli’s utility models. More recently the work of Louis Bachelier at the turn of the twentieth century produced a model that – eventually – had major ramifications for both subjects. Bachelier identified the random walk processes behind the phenomena of Brownian motion – the arbitrary movements of elementary particles – which also happens to be the underpinning of efficient market theories.

Bachelier’s work predated Einstein’s breakthrough on the same subject by a full half a decade but, as is science’s somewhat arbitrary way, was ignored at the time. In fact it was over half a century before a researcher happened upon some of Bachelier’s later work in the library at Yale and started asking colleagues whether they’d ever heard of him. Over at MIT Paul Samuelson went looking and discovered the Frenchman’s original 1990 work: here, already formed, lay the basis of the Efficient Market Hypothesis.

Mindless Agents, Beautiful Minds

It should, hopefully, be fairly obvious where the difficulty in modelling an economy as a set of particles bouncing around in a random fashion lies. The basic elementary unit of physics is a mindless, unthinking atom. Tempting as it is to complete the analogy the reality is that the elementary unit of an economic system is a mindful, conscious human. We make plans and decisions and generally operate in ways that atoms would find pretty distasteful. Although at least we don’t arbitrarily switch between particle and wave form every time we walk through a door.

The main reaction of econophysicists to the awkward tendency of humans to be imperfectly rational is to ignore it. The so-called theory of rational choice is the main way in which this rather odd approach to economics is modelled, based around the concept of a Nash equilibrium where non-cooperative but rational humans end up in a position of economic stability. Unfortunately such a system is unrealistic in the real-world, but that hasn’t stopped researchers spending a great deal of time developing models to show how it would work if it wasn’t unrealistic.

Bounded Rationality and Zero Intelligence

Alternative econophysics approaches involve the ideas of bounded rationality and zero intelligence agents. Bounded rationality assumes that people are basically rational but with limitations and has the great virtue, so econophysicists think, of being parsimonious – that is, it uses a few basic ideas to generate a complex model. Zero intelligence agents are also rationally bounded, the idea being to start with completely random elements – think atoms – and then gradually introduce bits of intelligence to see if this produces more or less realistic behaviour.

While all of this physics based modelling is interesting, and especially so for those looking for repeatable models of the way economic systems work in order to make money out of them, they all face the unenviable problem that the fundamental particle of their system is the recalcitrant human being. And underlying this creature is the so-far unfathomable nature of consciousness.

Reductionism

Pretty well all models based on physics rely on the concept of reductionism – the continued and repeated breaking down of physical properties to their smallest element. So, the physics of physical properties has gradually been reduced into smaller and smaller elementary particles until physicists have ended up with a model of everything which doesn’t seem to work very well unless you assume that the majority of matter in the universe has gone on an extended holiday in search of cosmic karma. The current quest for the so-called God particle – the Higgs Boson – is the outcome of this process.

Regardless of the current state of the unified model of everything the process of reductionism, allied to a scientific method which, as outlined by Karl Popper, requires all hypotheses to be testable and falsifiable has led to four centuries of unparalleled discovery in the physical sciences. However, the science behind consciousness currently seems to have created the scientific equivalent of cognitive dissonance.

When science runs into a dead end philosophers take over. Philosophers are like scientists without the need for empirical proof or, often, the need to take the real universe into account. From time to time, to make a point, they extrapolate to universes that don’t actually exist but could exist if only the current one, annoyingly, didn’t. Unsurprisingly if you put two philosophers in a room you tend to get a catfight, without any of the attendant rules.

The Origins of Consciousness

Arguments about consciousness tend to generate lots of heat and little light. Clearly, at root, human self-awareness is somehow grounded in the physical properties of the brain but equally clearly it’s pretty obvious that the various atoms, electrons, quarks and bosons that constitute our wetware don’t possess consciousness in and of themselves. Somehow consciousness emerges from the way that this all fits together.

Some philosophers like Daniel Dennett believe that an understanding of consciousness is simply a matter of understanding the underlying physical properties of the brain. Dennett stands firmly on the side of reductionist science. Others believe that consciousness is an emergent property, somehow based on the sum of the parts being greater than the individual neurons. Yet others believe that consciousness is learned. Julius Jaynes in his magisterial The Origin of Consciousness in the Breakdown of the Bicameral Mind suggests that early humans operated not on the basis of consciousness but through schizophrenic instructions from the right side of the brain and only gradually learned to stop hallucinating. Well, most of the time anyway. This isn’t exactly a mainstream view, but it is entertaining reading.

Given the lack of agreement on what consciousness is, let alone where it comes from, it’s unsurprising that we can’t develop models around it. Psychologists are, at best, statisticians relying on measurements of group behaviour under given conditions. None of this is very helpful in trying to predict the fluctuations of stockmarkets when conditions keep on changing and so most of the attempts to model economic systems tend to ignore the wanton ability of investors to attempt to think for themselves.

Think, Don’t Follow

Worse, we know that much human behaviour is triggered by unconscious biases – although we can override most of our worst tendencies we generally don’t, preferring to be swept along in crowds and reacting to our guts rather than our heads. Arguably accurate models of consciousness would simply generate idealised rather than accurate behaviour.

Even economists aren’t very happy with the results of econophysics. Worrying Trends in Econophysics sets out the case for the prosecution and McCauley that for the defence. The odd thing about these papers is the lack of any reference to actual people. Ultimately any proper definition of economic behaviour must somehow simulate the way that brains work, under different conditions. Simplified, parsimonious econophysics will always go wrong at some point: worse, it’s impossible to predict when. Relying on it is like relying on a plane with faulty landing gear. You know it’s going to end badly, you just hope you’re not on board when it does.

Given the current limitations on understanding how and why people really behave the way they do the safest approach is to assume that all models, however persuasive, are wrong because the ideal of rational man is lurking somewhere deep inside the workings. Rather than relying on others simulating consciousness we’re better off engaging our own.

Related Articles: Mandlebrot’s Mad Markets, Science, Stocks and Superstition, Bacteria, Boids and Market Instability

Bacteria, Boids and Market Instability

The Gaps Between People

Old-time economics saw investors as rational individuals, all behaving autonomously in a logical fashion, rather like Mr. Spock umbilically attached to Deep Thought. Today not even economists really believe that this is how people actually operate, but figuring out something better is a not insignificant task. Psychologists, however, have long known that what happens in the gaps between people is as important as what happens in the gaps between their ears – so is there something going on in the interactions between investors, which causes market instability?

One possible answer comes from the study of bacteria. Just as we might have suspected all along, stockmarket investor behaviour can be modelled by examining the way a bunch of brainless, single celled and barely animate creatures interested only in food and reproduction disport themselves on a Petri plate. Sometimes analogies are just too sweet.

Investing Earthquakes

The critical thing about any economic model is that it arrives at results that look like what we actually see in markets. Mostly the jargon fixated commentators who dominate the media are happy to talk in terms of business cycles when, in reality, the only cycles seen in most investing circles are the ones used by the boys and girls delivering lunchboxes. What we actually get, if we look at stockmarkets and stock prices, is something that looks like the readout we see from a seismograph when an earthquake occurs.

If we start by making a few assumptions about what investors actually do in real life – like, for instance, that they don’t behave rationally and that they tend to copy successful behaviour from people they’re closely connected to – we can rapidly create a model that produces outputs that look very different from those generated by models of people who behave independently and rationally. In fact the output of these models looks a lot like the readout we see from a seismograph when an earthquake occurs.

So it seems that the interactions between investors and how these interactions affect their willingness or otherwise to invest is the critical thing in these models. Fundamental value is, in fact, not the most important issue most of the time. Indeed, what seems to be really important is the internal behaviour of the participants, not the external behaviour of companies out in the real-world. Which simply confirms the suspicions of harassed leaders of industrial companies – the markets don’t care about real business issues.

Of Birds and Bacteria

Oddly enough the synchronised behaviour necessary to generate the type of herding needed to make this model work has been seen in various naturally occurring systems, including birds and self-propelled flagellant bacteria. The vast flocks of birds that sometimes arise, wheeling in perfect synchronicity, are utter marvels of the animal world. How can one bird, at the edge of the flock, move in tandem with another on the other side? Some deep thinkers have suggested that this can only be due to animal telepathy, but these people are, frankly, idiots.

The explanation is much more prosaic. It turns out that we can replicate this behaviour simply by using a few rules about how any given bird interprets the behaviour of the birds around it. A change at one edge of the flock can ripple through the whole in a matter of seconds purely by each individual bird reacting to the ones around it. There’s been lots of computer modelling done to show this working with so-called boids. Certain types of self-propelling bacteria demonstrate the same type of behaviour. However, if you introduce noise into the system, so that the creatures can’t communicate very effectively, then the synchronisation breaks down.

If the standard unsynchronised bacteria are our investors in their normal modes and the synchronised ones are what happens at market extremes when noise levels drop it’s fairly easy to see how the connectivity of the various agents is critical. In a world in which mass, instantaneous communication is prevalent it’s perhaps no surprise that we’re seeing more instability in markets and economies. The transmission of information, fear and greed is simply faster and easier than ever before – and we should therefore expect far greater and faster displays of irrational exuberance.

Phase Transitions in Markets

These types of models where we see sudden switches between different states are characteristic of something known as a phase transition. Phase transitions occur naturally and are unquestionably hard-wired into the structure of reality. Only we don’t quite know how or why.

For example, we see a phase transitions when water boils. This transition happens across the whole substance instantaneously, as if all of the molecules simultaneously decide to stop doing one thing and start doing another. This looks an awful lot like what we witness in our bird flocks as each molecule reacts to the ones around it and the change flows through the material.

A number of researchers have suggested that a type of phase transition (technically known as log periodic) marks the point at which markets crash: when suddenly all the parts of the system instantaneously align their behaviour and everything changes on the lazy flap of a single butterfly’s wings. Indeed they go further and argue that because such events have a typical signature in terms of oscillatory behaviour it’s possible to detect them ahead of time.

Marxist Instability Rules

Lots of work has gone on to prove this by looking at historical records of crashes. This research by Sornette and Johansen gives an overview but is a few years old now and work has continued apace in the meantime. The fits that the researchers have been able to obtain have been rather impressive. Unfortunately hindsight doesn’t make anyone rich and attempts to predict future market crashes have so far been, and let’s be kind here, completely, utterly and abysmally wrong. Worse still, if the predictions did come true and people started to believe their models then the predictions would start to fail because behaviour would change to incorporate the new reality. It’s really, really tough being an economics researcher.

Karl Marx theorised that the capitalist model demanded that there was inherent instability – that the periodic booms and busts we see are an inevitable property of the market economy. He went on to draw some rather larger conclusions about the result of these fluctuations which ultimately led to the deaths of tens of millions of people and some really bad architecture so we shouldn’t be blasé about the power of economics to affect our world. Still, his underlying premise seems to be as sound as ever: markets are fundamentally inclined to instability. There is no end to boom and bust and there never can be.

And if you don’t believe me, ask a bacterium.


Related Posts: Newton’s Financial Crisis, The Tragedy of the Financial Commons, Akerlof’s Lemons