Home » Opinion » Book review
Math models can't predict the market
By Wu Jiayin |
October 24, 2009, Saturday
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LIKE many other individual stock buyers, my father watches almost every day live TV programs in which stock analysts forecast the trend of China's stock market and recommend stocks with "high potential."
But he tends to take the analysts' opinions with a grain of salt as he finds their predictions turn out to be wrong from time to time.
I noticed that the stock analysts themselves often do not reach a consensus. Yet each of them, either by applying complex mathematical models or by quoting so-called "authoritative" statistics, makes their opinion sound reasonable.
Rather than believing in those stock analysts, individual stock buyers ought to heed the advice of Pablo Triana, author of "Lecturing Birds on Flying": mathematical theories can by no means help predict the financial market.
"In the markets, prices move for one reason only: human action," Triana observes. "There is no theory in finance. There can't be."
He believes that mathematical approaches could only work in physics but not in finance: physicists study particles, and particles do not make up their own minds. Economists study the results of human decision making, and people are not predictable.
The highlight of Triana's book is his valuable insights into the problems with mathematical economic models, which make his argument quite forceful.
One of the most recent big market trends that experts failed to forecast with their various mathematical economic models is of course the global financial crisis.
And it is no exaggeration to say that the models, which guided risk-management decisions about mortgage-backed securities, largely contributed to the credit crisis.
As Triana observes, "The hugely sizable, hugely geared bets on subprime-related assets ... were made possible by an industry-standard, regulators-endorsed, risk-management concoction with a habit for downplaying upcoming market turbulence and for recommending timid capital requirements."
Value at Risk (VaR) is a quantitative metric that claims to measure the most that a portfolio of financial securities can lose. It is quite popular among risk managers at major financial institutions.
The problem with VaR is that while it works in reasonably stable markets, it often fails when abnormal events take place.
For instance, on February 29 last year, Bear Stearns reported an aggregate VaR of only US$62 million, but when the company collapsed, the loss turned out to be much bigger.
There were similar cases with Lehman Brothers and Merrill Lynch.
It is undeniable that the undervalued VaR encouraged imprudent investing and contributed to the bankruptcy of those companies.
No wonder statistician-author Nassim Nicholas Taleb has proposed jailing the quants (quantitative analysts) who brought about the mortgage-backed securities fiasco.
Triana has also attacked universities, especially business schools, which, in his view, is the root of the blind belief in the highly questionable mathematical models.
As professors in business schools usually have little experience in the real world, they tend to be over enthusiastic with theoretical financial models without the ability to identify the models' limitations or weaknesses. Moreover, that's often where the aspiring scholars can make money.
However, "business is ... a practical, non-theoretical discipline where the difference between having done it and not having done it can be the difference between real knowledge and make-believe," Triana says.
Aware of the destructive impact of mathematical models in the financial arena, Triana even proposes eliminating the Nobel Prize in economics. Although the suggestion doesn't sound practical, it fully expresses Triana's skepticism about those troublesome models.
Indeed, while it is human nature to seek certainty, it is better to teach investors the truth that investment in the financial market is highly risky and that no mathematical model can help them control or reduce risks.
But he tends to take the analysts' opinions with a grain of salt as he finds their predictions turn out to be wrong from time to time.
I noticed that the stock analysts themselves often do not reach a consensus. Yet each of them, either by applying complex mathematical models or by quoting so-called "authoritative" statistics, makes their opinion sound reasonable.
Rather than believing in those stock analysts, individual stock buyers ought to heed the advice of Pablo Triana, author of "Lecturing Birds on Flying": mathematical theories can by no means help predict the financial market.
"In the markets, prices move for one reason only: human action," Triana observes. "There is no theory in finance. There can't be."
He believes that mathematical approaches could only work in physics but not in finance: physicists study particles, and particles do not make up their own minds. Economists study the results of human decision making, and people are not predictable.
The highlight of Triana's book is his valuable insights into the problems with mathematical economic models, which make his argument quite forceful.
One of the most recent big market trends that experts failed to forecast with their various mathematical economic models is of course the global financial crisis.
And it is no exaggeration to say that the models, which guided risk-management decisions about mortgage-backed securities, largely contributed to the credit crisis.
As Triana observes, "The hugely sizable, hugely geared bets on subprime-related assets ... were made possible by an industry-standard, regulators-endorsed, risk-management concoction with a habit for downplaying upcoming market turbulence and for recommending timid capital requirements."
Value at Risk (VaR) is a quantitative metric that claims to measure the most that a portfolio of financial securities can lose. It is quite popular among risk managers at major financial institutions.
The problem with VaR is that while it works in reasonably stable markets, it often fails when abnormal events take place.
For instance, on February 29 last year, Bear Stearns reported an aggregate VaR of only US$62 million, but when the company collapsed, the loss turned out to be much bigger.
There were similar cases with Lehman Brothers and Merrill Lynch.
It is undeniable that the undervalued VaR encouraged imprudent investing and contributed to the bankruptcy of those companies.
No wonder statistician-author Nassim Nicholas Taleb has proposed jailing the quants (quantitative analysts) who brought about the mortgage-backed securities fiasco.
Triana has also attacked universities, especially business schools, which, in his view, is the root of the blind belief in the highly questionable mathematical models.
As professors in business schools usually have little experience in the real world, they tend to be over enthusiastic with theoretical financial models without the ability to identify the models' limitations or weaknesses. Moreover, that's often where the aspiring scholars can make money.
However, "business is ... a practical, non-theoretical discipline where the difference between having done it and not having done it can be the difference between real knowledge and make-believe," Triana says.
Aware of the destructive impact of mathematical models in the financial arena, Triana even proposes eliminating the Nobel Prize in economics. Although the suggestion doesn't sound practical, it fully expresses Triana's skepticism about those troublesome models.
Indeed, while it is human nature to seek certainty, it is better to teach investors the truth that investment in the financial market is highly risky and that no mathematical model can help them control or reduce risks.
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