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The science of the stock market


After 145 years, the Toronto Stock Exchange’s 30,000-square-foot trading floor, where traders bought and sold equities primarily by shouting at each other at the top of the their lungs, closed recently. Buying and selling can now be done much more quickly, easily and efficiently using computers, so the TSE has gone to a completely automated system.

Of course, to make money, you still have to be able to predict what the market is going to do. Fortunately, some analysts can. They’re only occasionally right–but that’s enough.

A new study confirms their ability. In 1967 Nobel Prize-winning economist Paul Samuelson said “a typical mutual fund is providing nothing for the mutual fund owner that they could not get by throwing a dart at a dartboard.” In response, since 1988, the Wall Street Journal has run a monthly column pitting investment professionals against darts.

Allen Atkins, a finance professor at the University of Arizona, studied the results and found that in 79 contests, human stock analysts won 45 times to the darts’ 34. As well, expert-selected stocks typically increased in value by 1.41 percent more than the Dow Jones average in a month, while dart-selected stocks fell 1.75 percent behind.

Even such limited success is remarkable considering the volatility of the stock market. To begin with, stock prices rise or fall more on people’s expectations than on actual events. If a company is expected to pay a big dividend, its stock price will rise–but if that company then pays a less-than-expected (but substantial) dividend, the price will fall. The company is still profitable, but it’s not living up to expectations.

How investors react to events also depends on such intangibles as how they feel. Just as a temperature of five degrees feels like heaven in January and hell in July, so the same event–say, a rise in unemployment–can effect the market either positively or negatively, depending on the mood of investors, based on other recent events.

Herd mentality also plays a role. If the illusion can be created that a stock is rare, and a few “experts” can be convinced to buy it, the stock’s price may take off as everybody rushes to get in on the deal. After all, if “everybody else” is buying a stock, they must know something you don’t. The rush of buyers inflates the stock price even more–often far above what it should be worth, in which case, somebody eventually gets burned.

Investors hang on to bad stocks long after they should have bailed out because of “loss aversion behavior,” according to Werner De Bondt, associate professor at the School of Business at the University of Wisconsin-Madison. Once you sell, your loss seems permanent, so you hang on, hoping the stock will rebound.

With all these forces driving investors, it’s no wonder the stock market seems utterly chaotic. Which brings us back to the question, how do analysts make successful predictions?

Doyne Farmer, a physicist who helped found the science of chaos theory, heads the Prediction Company, which is using chaos theory to try to beat the market. He says analysts make successful predictions the same way baseball players catch flies. A player doesn’t solve the equations governing the trajectory of a ball. Instead, he relies on a mental model of how the ball will behave, based on having seen thousands of them come his way. Similarly, over many years a top stock analyst unconsciously builds up mental models of how the market behaves, and is thus able to pick out stocks that are likely to increase in value over the short term.

Even though the stock market, like the weather, is a chaotic system, and therefore cannot be predicted with any accuracy over the long term, within chaotic systems there are often localized areas of predictability, Farmer says. Like sailors scanning the sky and predicting wind by nightfall, top market analysts recognize and take advantage of local predictability.

Farmer is trying to create computer systems that can do the same thing. You don’t have to be right very often to get rich in the stock market, he points out.

With traders using computers to buy and sell stocks and even to tell them what to buy and sell, the stock market has come a long way from two guys yelling at each other at the top of their lungs.

It may be not be as colorful, but at least it’s quieter.

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