Portfolio theory: The human factor
Computers can do a lot to process today's explosion of information in financial markets - but they're only a tool. The ultimate processor and user of the information is man. Man is the subject and the object of financial analysis. Markets are a theatre of human behaviour. More and more quantitative analysts are redirecting their study of markets to the study of man. David Shirreff reports.
The study of markets is still in its infancy. We know that, when only three or four people gather together to trade, there is already a recognizable market. At that level, game theory can explain a lot, as participants take account, not only of the fundamentals governing the commodity traded, but also of each other and the views they might take. But even at this level, game theory might explain behaviour, but it cannot predict market outcomes.
As the size of the market increases, so does its complexity. Factors other than fundamentals and gamesmanship come into play - time horizon, liquidity, experience of traders, entry of new traders, reactions to past gains and losses, influence of analysts. Perhaps the most complex existing market is the market for US equities.
Some humans can understand intuitively a great deal about markets. They can scan the complex factors governing a market far more efficiently than any computer. They may not process as much information, but they don't need to. They can select information with more agility than any computer has yet been taught to do.
The human brain can "appraise things faster than you can blink", says Arnie Wood, president of Martingale Asset Management, Boston.