The Future is “Theory-Free”

The dusk is setting in on the world of factors and economic theory. If my views seem dramatic or extreme, consider that the markets did not make sense from a CAPM world view during the best (and simplest) of times. Today, the world markets are a strange and dangerous place. We are in the midst of the era of dominance for computerized trading (think Skynet from the Terminator). Floor trader jackets will soon become museum relics or sold as collector’s items on E-Bay. Most of the retail investors and individual traders have left the market entirely–outclassed, outgunned and tired of poor returns and being unable to compete. We are simultaneously in the throes of perhaps the greatest financial mess of all time. Our pithy attempts to control the uncontrollable with the aide of simplistic economic theory, political idealism, and crony capitalism has put the world in a perilous situation. The stress in financial markets reflect unprecedented levels of global debt, government intervention, unexpected shifts in sovereign risk, and banks that can lose billions for no obvious reason seemingly overnight.

The complexity of the modern world, and the degree to which it is interconnected, has rendered simplistic linear theory almost meaningless. Human behavior- a feature once predictable in its hybrid version of rationality and cognitive bias- no longer manifests in markets as a fluid mass of “greed” and “fear”. Instead, game theory and behavioural finance now share equal importance as players engage in Keynesian beauty contests with greater than six degrees of anticipation. (not to be confused with six degrees of separation) http://en.wikipedia.org/wiki/Keynesian_beauty_contest . The highly complex interaction between governments, banks, hedge funds, institutions, wealthy individuals, and high frequency firms is a multi-dimensional high stakes game where the rules change by the day. Players must interpret or anticipate others actions, the perception that other players have of their actions, and how rules might change and how this may affect their actions and perceptions. And this is a simplistic description……………..

The future of investing must be theory-free and focus on creating algorithms that can adapt to change and adequately capture the nature of complex systems. Ed Seykota once correctly observed that a surfer does not need to know the theory of fluid mechanics to learn how to surf a wave in the ocean– he needs only to be able to make probabilistic estimates and adjustments. This example puts the financial economist at odds with the scientist or the engineer. The future favors the practical problem-solvers, the inventors, the gamers, and the deep thinkers. Investing is becoming like the evolution in mixed martial arts– no single style or background is likely to win, nor is a stubborn resistance to learning about other disciplines. I predict that the theory police will resist this transition and be left standing naked before their disciples when the tide goes out. It is much easier and more comforting to explain the world in deterministic terms- replete with graphs of marginal utility and “proofs.” Of course it is also more comforting to play chess than engage in a high stakes game of “liar’s poker”.

It is important for quants to override the desire to be fed theoretical pablum and avoid trying to seek academic approval from high priests of a defunct religion. There is nothing wrong with learning finance, economics or econometrics- in fact it is crucial to understand these disciplines at a high level. But it is time to start thinking for yourself, and to stop being a sheep. Instead one should favor asking hard questions, learn to think independently, collaborate effectively, and most importantly spend their waking hours thinking about how to solve high-dimensional classification and game-theoretic problems.