Big Ideas

Can the laws of physics and information theory help explain human psychology, specifically as exhibited by investors? In the December 2005 update of his paper entitled “The Physical Foundation of Human Mind and a New Theory of Investment”, Jing Chen: (1) builds upon the similarities between the mathematics of information theory and of physical entropy to explain certain human thinking patterns; and, (2) uses this synthesis to unify understanding of the behavior of financial markets. He posits that human thinking patterns are adaptations evolved (mostly in hunter/gatherer mode) to acquire efficiently the resources needed for survival, as constrained by physical laws. In a mostly theoretical discussion, he offers the following insights: Keep Reading

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network (SSRN). Here we summarize the August 2003 paper entitled “A Theory of Large Fluctuations in Stock Market Activity” (download count nearly 2,700) by Xavier Gabaix, Parameswaran Gopikrishnan, Vasiliki Plerou and Eugene Stanley. Why do stock prices vary more than company fundamentals? Why do stock markets crash? This paper proposes a theory of large stock market movements based upon a linkage between market activity and the size distribution of large financial institutions. Motivated by empirical findings that stock returns, trading volumes, number of trades, price impacts of trades and sizes of large investors all have power law distributions, the authors propose that: Keep Reading

Because economics and financial markets lack mature theoretical (deductive) foundations, these fields involve largely empirical (inductive) work. The principal mathematical tools in this pursuit derive from probability and statistics. In his 2003 book Probability Theory, The Logic of Science, E.T. Jaynes presents in textbook form his own evolutionary growth in the understanding of probability theory. His approach is Bayesian, in that he views probabilities as conceptually distinct from frequencies of occurrence and probability theory as synonymous with the process of inductive inquiry. He emphasizes iterative “plausible reasoning” as the kernel of probability theory. He offers a few summarizing points relevant to equity investors/traders, as follows: Keep Reading

In his 2002 book, Reinventing The Bazaar, A Natural History of Markets, John McMillan offers an overview of recent research on the workings of markets. His perspective is empirical rather than ideological as he examines economies worldwide to infer when markets work and when they do not. Some summarizing points on critical factors for economic growth are relevant to equity investors considering international diversification, as follows: Keep Reading

How much buying and selling comes from picking stocks rather than assuring diversification by use of stock indices? Is stock picking a dying practice? In their November 2005 paper entitled “Is Stock Picking Declining Around the World”, Utpal Bhattacharya and Neal Galpin model and measure the relative proportions of stock picking and index use in the United States and elsewhere. Their model measures the level of stock picking via the relationship between stock trading volume and firm market capitalization. Using data for stocks in 43 countries (21 developed and 22 emerging) beginning with 1962 in the United States and focusing on 1995-2004 for cross-country analysis, they find that: Keep Reading

In his 2004 autobiography, My Life as a Quant, Reflections on Physics and Finance, Emanuel Derman recounts his experiences as a physicist driven by the forces of employment supply and demand to redirect his labor toward quantitative financial analysis/strategy. Knowledge and skills critical to his transition are: a sense of how the world works, modeling and programming. Much of the book is a straightforward recounting of activities, personalities and reactions, culminating in Mr. Derman’s derivatives modeling accomplishments. Toward the end of the book, he offers a few essential distillations, as follows: Keep Reading

We have selected for retrospective review a few all-time “best selling” research papers of the past few years from the General Financial Markets category of the Social Science Research Network. Here we summarize the August 2002 paper entitled “Demography and the Long-Run Predictability of the Stock Market” by John Geanakoplos, Michael Magill and Martine Quinzii (download count over 4,400). In this paper, the authors link cyclic demographic behavior (borrowing when young, investing for retirement in middle age and disinvesting in retirement) with stock market price-earnings ratio (P/E) cycles. Using the overlapping generations model, they conclude that: Keep Reading

Didier Sornette has an interest in financial markets as examples of complex systems. He authored Why Stock Markets Crash : Critical Events in Complex Financial Systems, published in November 2002. He has maintained on his web site for several years a series of predictions regarding the behavior of the S&P 500 index. In initiating this series, he wrote:

“Based on a theory of cooperative herding and imitation working both in bullish as well as in bearish regimes that we have developed in a series of papers, we have detected the existence of a clear signature of herding in the decay of the US S&P 500 index since August 2000 with high statistical significance, in the form of strong log-periodic components.”

His September 2002 paper (with Wei Zhou) entitled “The US 2000-2002 Market Descent: How Much Longer and Deeper?” provides a detailed justification of this assertion, including a comparison of the 1990 Japanese and 2000 U.S. stock market crashes. The evolution of Professor Sornette’s predictions is as follows: Keep Reading

Nassim Taleb’s central theme in Fooled by Randomness (the 2004 second edition) is that noise generally swamps signal (true outperformance or underperformance) in financial markets, and in life generally. A standard deviation much larger than an associated average excess return, encountered consistently in the search for outperforming investing/trading strategies, is an indicator of such swamping. The book effectively uses corollaries and examples to reinforce Nassim Taleb’s contention that past performance is neither a guarantee of future returns nor a proof of either intelligence or stupidity. Rather than recount his arguments, we focus this review on his conclusions as they relate specifically to speculating in financial markets. These conclusions are: Keep Reading

Professor Aswath Damodaran of the Leonard Stern School of Business at New York University offers on his web site a broad and deep set of financial education materials covering: corporate finance, investment (portfolio) management and valuation. He presents considerable information from his books, such as Investment Philosophies and Investment Fables, including supporting data. For example… Keep Reading