Markets And Methods

In 300 years of human evolution, stock markets lagged behind other streams of activity. This awareness helps one to make successful investments.

When you buy a call option of Tisco, you are buying a financial instrument that has been in use for centuries of a company that is 90 years old, making a product that in some form or the other has been used by human beings for thousands of years. Why is this significant?

Very little seems to have been changed in the world of markets. From trading in options of East India Company in 1690 in London Change Alley to those of Tisco in 2005, the only difference is where it is traded. Today, we have an electronic market to trade in, while in the 1690s, trading was in smoke-filled rooms and dark narrow alleys. So the change, over almost 300 years is not in the market elements, such as issuers and instruments and the reasons why these are bought and sold. The change is in the technology. The real area of change was not brought about by finance but by the relentless march of scientific progress.

This says a lot about the progress of financial markets as an area of human activity. Consider instead the progress made by medicine and astronomy over the last 300 years. Or even by the economics of capitalism, the "dismal science" that started its formal journey as a discipline in the late 18th century when Adam Smith wrote his path-breaking treatise. By the way, even at that time, Smith was not called an economist. If Adam Smith were carrying a calling card then, it would say, ‘Moral Philosopher’.

Slow Progress, Much Regress

For all the headlines it occupies and the attention it gets, the stock market as a field of human endeavour has been slow to develop and is still beset by the same motivations, practices and instruments as were prevalent centuries ago. Indeed, there has even been much regression. Financial innovation that worked fine at one time has been junked and then revived - sometimes centuries later. Stock options were formally introduced in India in 2001 - almost 300 years after it was a flourishing instrument in Amsterdam and London, and decades after they stopped being informally used in India. Commodity futures were banned in 1969 in India and brought back in 2003. This kind of time warp has affected even other aspects of finance. For instance, today, we are going back and forth on the issue of private financing of infrastructure projects. One of the major projects at the turn of the previous century, the Panama Canal, was privately funded. After seven decades of misguided ideas of socialism, we are rediscovering simple financial ideas that have worked so well in the past.

This is unthinkable in physics, medicine and other streams of science. It is as if penicillin was discovered and used extensively, then forgotten for 100 years and revived again as a useful drug to fight bacteria. Or that Newtonian physics was found to be useful, like stock options, when Newton was alive, then fell into disuse until the 20th century scientists found it useful again to explain many natural phenomena.

New drugs and new ways to fight disease are being discovered, drawing from the knowledge of earlier generation of drug discovery. New materials such as carbon composites are being developed as relentless advancement to discover tougher and lighter material. We are not stuck with steel and aluminium. Current scientists always stand on the shoulders of their earlier generations of scientists.

In short, scientific knowledge is accretive, accruing more or less systematically and progressively over a period of time. Financial knowledge is random, not progressive and sometimes even regressive. What if scientific methods and approaches are applied to markets? The results are very interesting, as we shall see below.

What has a statistical tool called multivariate analysis got to do with understanding where the stock market is headed.

In the above issue, We had initiated the thought that very little seems to have changed in the world of stock markets. Over the past 300 years of stock trading, there has not been much change in the main market elements: the issuers, instruments and reasons why stocks are bought and sold. This is in sharp contrast to, say, scientific progress. Today’s scientists stand on the shoulders of earlier generations of scientists. Scientific knowledge is accretive. But progress in financial innovation has been random. There has been too much of back and forth, too many twists, turns and retracements.

What if scientific methods and approaches are applied to stock markets? The towering figure of this approach is ace speculator Victor Niederhoffer, a legend on Wall Street. He has pioneered what is called the quantitative study of the market, which relies on a scientific approach. According to Niederhoffer, the starting point of this approach is defining the scientific method itself, which the Oxford English Dictionary defines as “a method of procedure that has characterised natural science since the 17th century, consisting in systematic observation, measurement and experimentation and the formulation, testing and modification of hypotheses.”

Victor, who is extraordinarily erudite, points out in his book The Education of The Speculator that the flavour of scientific methods “was described by Davy as analogy confirmed by experiment; by Stanley Jevons as discovering identity among diversity; by Walter Pater as the analysis of rough and general observations into groups of facts that are more precise and minute; and by Herbert Spencer as finding sequences among phenomena and grouping them into generalisations.” In essence, scientific work involves classification, observation, questioning, testing, measuring, collecting information, experimenting, modeling and revising theories.

How many stock brokers or fund managers employ this kind of complex approach in dealing with stock markets which are ever-changing and mysterious? How many of them proceed by observation, insight, hypotheses and trial, rather than relying on hunch or crude tools of price trends and earnings forecast? They don’t, which is why scientific theories stand the test of time while stock market predictions don’t.

How does a scientific process help? In an uncertain world, it helps reduce the margin of uncertainty. It helps in overturning incorrect ideas or market myths as we call them. As Victor puts it, “errors in judgment are particularly frequent in choices involving uncertainty and risk.” The scientific tool designed to deal with uncertainty is statistics, mainly probability, and Victor has done path-breaking work in applying probability to markets.

Applying mathematics to markets is not rare. Victor is only the most celebrated example. There are boutique research firms that apply high-end computers to crunch market data applying sophisticated mathematical tools. Victor trades strictly on the basis of statistical anomalies and the quantification of persistent psychological biases. He owes his influence to Francis Galton, the inventor of weather maps. Victor came across Galton while studying the influence of weather on sporting outcomes. Galton’s favourite motto was, “Wherever you can, count.” He traveled with a pin and an index card so that he could tabulate anything that struck him as noteworthy.” As Galton himself said it in his book Memories of My Life: “I frequently make statistical records of form and feature, in the streets or in company, without exciting attention, by means of a fine pricker and a piece of paper…The holes are easily counted at leisure, by holding the paper against the light, and any scrap of paper will serve the purpose...”

If only market experts took the trouble to incorporate even a fraction of this approach, the public would be losing much less money. In the US, two speculators have taken the scientific path and have been amply rewarded.