I have been reading John Allen Paulos’s A Mathematician Plays the Stock Market, which has been entertaining. It combines the author’s real-world anecdotes with some psychology, everyday math, and game theory to create a pleasurable bit of reading. It appeals to the logician in me. The book discusses various approaches to investing starting with “emotional investing” — which lead to the Paulos’s fated love affair with WorldCom — then technical analysis, and finally fundamental analysis. I assume that other investment strategies are investigated as well, as I am only half way through the book. The author applies common sense and mathematics to shed some light on each strategy.
I picked up the book because I’ve grown interested in the application of neural networks and complex adaptive systems to understand (and profit from) financial systems. I am not the first person to think of this. Clearly, there is a lot of research in this field. However, before I jumped into crazy levels of math theory, AI theory, and financial theory (all of which intrigue me), I wanted a light introduction to the application of math theory to the stock market.
I am inclined to believe that the stock market is not truly random because individuals do not make buy and sell decisions randomly — they do not base their decisions on, say, a flip of a coin or other truly random phenomena. Individuals have intellegence and an intent to profit, and they make their decisions based on their expectations of the future. Part of those expectations include anticipating other people’s expectations of the future. Buying and selling can be influenced by near-random external events (for example, natural disasters), but those events do not inherently impact the market — it is the buy and sell decisions made by people in reaction to the event that impacts the market.
Still, it is possible to not be truly random but have all of the affects thereof — just think of a good pseudo-random number generator. I am undecided on whether I believe that share prices or market indexes are predictable. However, I do not buy into the efficient market hypothesis. I have never fallen for the economist’s line: “let’s assume a perfectly rational investor…” I have never met such a person, so I call shenanigans on economists and their silly assumptions made to simplify the math involved.
