Sunday, April 27, 2014

Financial Markets: The Ultimate Complex System & Global Game

As I become an older man, I realize that I have already spent a significant part of my life studying and following the financial markets. I have studied history (which I believe is the most important area) as well as the philosophy and tactics behind the most successful investors, both present and past.

Something I came to understand a good time ago and continue to reinforce almost daily is that no one has any idea what is going to happen next. The absolute best in the financial world, those that steadily rise to the top of the financial universe, put a vague picture together of some of the most likely scenarios that could occur and then try to build a strategy around those potential outcomes. The reason the absolute best in the industry cannot tell you what will happen tomorrow is because the financial markets are a complex system, a topic I will discuss in more detail in a moment. Before we get there, let's take a brief walk through the ever fascinating human mind. 

If someone tells you they have a model for the exact moment when a market is going to do something (usually through some sort of technical analysis or trading system), you should politely excuse yourself and walk away. This person does not make a living "timing" or "beating" the market; they make a living selling the belief to others they can do so. Any short term gains based on technical strategy are in reality based on statistical luck. The only way someone can "time" the market consistently in the short term is through some unfair or illegal advantage.

A few years back I remember reading an article about a young man who quit his job and began trading currencies. He was a self-described "prodigy" and told clients the story of how he turned $500 into $2,500 in a month and then consistently grew that capital exponentially through his god given talent to trade currencies.

He payed a PR firm over $3,000 a month to promote his image as a successful trader, and he released pictures of bar tabs he ran up at clubs around the world. He famously spent more than $125,000 on a single bottle of champagne, then posted the picture of the bar tab that night online. He created movies and lavish photo shoots to promote his stature as the next big thing in the financial world. 

This week it was discovered that he had been running a ponzi scheme. Clients poured money (over $2 million) into his trading firm to receive a portion of his legendary gains, which he then used to party and promote himself. The investors lost everything. 

When you hear this story from start to finish it seems impossible that anyone would give this 23 year old kid their money. What causes people to do this? 

The reason lies in the fact that the human mind is a solution driven machine. The mind is constantly and exhaustively searching for the answer to a problem it receives. When an answer is discovered it allows the mind to turn off that assignment and move on to the next problem.

As a quick side tangent, this particular trait of the human brain is what makes goals so powerful; the subconscious is constantly looking for answers around you that will bring that goal into your life. 

Many financial advisors or experts provide an easy to understand model or solution of how they beat or time the market, and they show recent success combined to back this up. This provides a quick solution to the mind's problem of "where to put my investment capital," and it allows the mind to begin working on the next project. The strain is now gone.

If else someone tells you that the market cannot be beat, and the best option is a never ending lifetime of study combined with research and development of your financial intelligence; it is far less appealing to your mind. This provides no quick solution to the investing problem your mind is trying desperately to get off its work load. 

In a well written paper titled Financial Markets As Complex Systems Professor Amitava Sarkar describes a complex system as:

- a collection of many interdependent parts
- that interact with each other through competitive nonlinear collaboration
- leading to emergent, self-organized behavior

He goes on to say that:

Financial markets can be regarded as model "complex systems." In fact, they are fascinating examples of "complexity in action": a real world complex system whose evolution is dictated by the decisions of crowds of traders who are continually trying to win a vast global "game."

What makes markets even more fascinating is that they are impacted by a series of other complex systems: politics, organizations (businesses), economies and natural human behavior. It is incredibly difficult to figure out how a single one of these four pillars will shift in the future, yet all four add an additional layer of information needed to try and determine a future outcome for the financial markets. The investors most likely to put capital to work successfully must be masters of all four pillars. This illustrates why winning in the financial markets represents the ultimate global "game."

It should also illustrate why someone who tells you that they have a technical chart showing where the market will move tomorrow is delusional. Those that take the simple investing solution so their brains can move on to the next task will unfortunately be slaughtered over the long term.

The fact that the financial markets and investing take a lifetime to master is exciting to me personally because it provides a global "game" where I can compete throughout the remainder of my life (long after I'm too old to play pick up basketball and perhaps even after I'm too old to play golf). For others who do not want to put in the extensive time to learn, just understanding how complex the financial market system is will put you far ahead of almost everyone because you can walk away from those providing the next "easy" solution to the most difficult game in the world.

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