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Simplicity at the Expense of Reality

October 20, 2010

We crave simplicity and elegance as human beings. It is the comfort of known laws be they physical or those that govern society that provide order to our lives. Our notions of the world are neatly boxed by our own limited cognition and inability to conceptualize the abstract or unfamiliar. In the financial markets the pronounced quest for simplicity has left us with incomplete and inadequate models such as the CAPM, beta, mean-variance optimization and the EMH (efficient markets hypothesis). Mathematicians are the kings of deriving solutions to complex problems from simple abstractions, and this proved to be an irresistable panacea to institutions and investors desperate for guidance. Little did they know the destruction that naiive deductions borne from complex proofs could wreak on their fragile portfolios.

If the financial markets could truly be deduced from the inspection of “financial laws” we might be able to peer at the workings of price movements as the bi-product of an aggregation of simple effects. Volatility ergo gravity, and other laws could neatly describe the landscape in which traders and investors operate. The “J and K” momentum effect, and the “Fama and French,” and many other “effects” discovered could be used as blocks to build a larger pyramid that describes precisely how the market works. In the quest to function like other branches of scientific academia, finance has created a crippling framework that requires a simple unified theory to organize the research. Since professors are no more righteous in defending their turf than the common man, we have spent years deeply entrenched in ludicrous theoretical debates that could never possibly describe something so complex as the stock market.  Followers of this research understand that the original troupe of the EMH brigade suppressed all dissenting studies from adding any perspective. Their actions taken in some cases to shun contradictory studies were so extreme that they shared more in common with radical religious or cult leaders. To say that these were true men of science–in the quest to find the truth– would be an insult to science itself.

But the beauty of being a religious leader is that few will question your assumptions–to be a professor at an Ivy League school is to be an unquestionable authority on the subject matter of your specialty. Both your students and members of the industry put unquestioning faith in the set of principles and body of knowledge that you present.  Bring together a band of such individuals with mutual goals, and invariably “groupthink” will prevail. The truth is, after 10 years studying the markets, I look back on my days as an MBA and all of my formal training much like a man reflecting on his childhood: 1) the naiive simplicity of life that you were presented by your parents was designed to shield you from the ambiguities and uncertainty of being an adult 2) reality is a lot less orderly than you ever imagined. 3) there are no easy answers to seemingly simple questions–the rules to guide your life that your parents taught you rarely apply in every situation.  The markets are exactly the same– no simple guide will tell us what to do, and even the experienced professionals seem to be confounded by relationships or events that they never thought possible.

The most optimistic quantitative researcher knows deep down that an unexplained noise dominates the data that mysteriously eludes linear models such as regression. Ardent neural network fans will acknowledge the tremendous instability of turnkey applications to improve prediction within the data. What order truly lies beneath the noise in financial markets can only be uncovered by exploring all avenues without bias or prejudice. If we limit ourselves by the neccessity of explaining things in terms that are familiar than we will neccessarily constrict our ability to discover the truth. Our desire for simple rules for trading, and simple laws for describing our world come at the expense of the reality of what the market actually is—anything else is a childhood fairy tale.

5 Comments leave one →
  1. Joe Marc permalink
    October 20, 2010 5:45 am

    Absolutely brilliant. As I have said to you before, you are very kind to share your knowledge and insights with us.
    It is appreciated.
    Joe Marc

  2. Chris Ciarpelli permalink
    October 21, 2010 2:24 am

    Had VaR also been mentioned in that 5th line, I’d of assumed that Nassim Taleb authored this post!

    • david varadi permalink*
      October 21, 2010 4:35 am

      hi chris, that is funny you mention that–now that i think of it you are absolutely right. I also should have mentioned Var….. oh boy don’t get me started on that one!
      best
      david

  3. david varadi permalink*
    October 21, 2010 4:34 am

    thanks Joe–I really appreciate the kind words.
    best david

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