Financial markets are more driven by whimsy and rumour than by cold, hard logic, according to two researchers who have developed a computer model for stock price behaviour.
The brokers would like you to think that wisdom and knowledge are all you need to make it rich but in fact the academics from Germany and Italy have shown that financial prices exhibit "universal characteristics" that resemble well- known laws of mathematics and physics. What it all boils down to is traders spend more time watching one another and chasing the herd than they do prognosticating the future.
Dr Thomas Lux of the department of economics at the University of Bonn and Dr Michele Marchesi of the department of electrical and electronic engineering at the University of Cagliari publish their findings this morning as correspondence in the science journal, Nature. They say that market price fluctuations look very much like "the scaling laws characterising physical systems in which large numbers of units interact". If in fact market prices are driven by the interaction of stressed-out pit traders, then this would be "in contradiction to the prevalent `efficient market hypothesis' in economics which assumes that the movements of financial prices are an immediate and unbiased reflection of incoming news about future earning prospects", they suggest.
To test the theory they created a model that has all the ingredients of exchanges in Dublin, London, New York or Hong Kong. They provided a mixture of broker types familiar to those who haunt markets anywhere. The researchers included "fundamentalist" traders who expect the price to follow the fundamental value of the asset. These are the steely, logic-driven guys who wear braces, have a Filofax at the ready and a laptop to do their spreadsheet analysis.
Next into the mix were the "noise traders". These are the ones who know the market follows it own logic. They look at charts for unexplained trends and, according to the authors, "consider the behaviour of other traders as a source of information, which results in a tendency towards herding behaviour".
The researchers even provided for optimistic and pessimistic noise traders, to get a more accurate model mix.
Drs Lux and Marchesi drain away much of the mystique and romance of the market when they tell us that in their model "we adopt a mass-statistical formalisation inspired by statistical physics: individuals react to certain economic forces by changing their behaviour with a certain probability". The mathematics is too difficult to describe but in effect their virtual stock market over time did what all good markets do, with long-term stock prices dutifully tracking along their actual underlying worth. In any given day or week, however, it also mimicked the market, with prices bouncing all over the place as the traders felt bullish or bearish, followed the rumours about bank buyouts or just got scared.
The key to the variations, the researchers say, depends on the traders switching their ground. Fundamentalists stick to the programme until they see a stock hit the roof and then quickly convert to optimistic noise traders. The optimists hear something bad while lurking in the washroom and then decide to become pessimists.
The mathematical "scaling properties" which describe this herd behaviour are absent in the forces which control the fundamental price of a share, the researchers say, and so "are generated by the interaction of economic agents" who pursue their own beliefs and strategies in this virtual market.
Why, they ask, is this so? "A closer investigation reveals that the alternation between tranquil and turbulent periods comes about through the changes of agents between groups. In particular in periods of high volatility we also find a large fraction of agents in the noise trader group." So the next time the market goes on a roller coaster ride, you will know who to blame.
