Monday, October 31, 2016

Finance: About Stock Markets And Quantum Physics

(Drivebycuriosity) - There is an old controversy whether stock markets behave randomly or if they reflect the fundamental facts. I think both approaches are correct, it depends on the time horizon.

In the very short run - daily or intraday - stock market movements are random, they are driven by noise (random news) or purely coincidental. If you take a longer term, the picture gets clearer the longer the time span goes.  Over 10 years and more the random aspects - flash crashes, intraday reversals, late nosedives and such - mostly disappear from the picture.







                                               Heisenberg`s Uncertainty Principle


This reminds me of physics. If you observe very small objects - electrons and other elementary particles - you get random movements, which are described by Quantum Physics. Experiments have shown that the behavior of particles like electrons is unpredictable. This is described for instance by the famous Heisenberg Principle, named after the physicist Werner Karl Heisenberg:  "The more precisely you know the position of a particle, the less precisely you can simultaneously know the momentum of that same particle" (physics). The behavior of these particles is uncertain (physics.about.com) and they "act" strangely & weird. Some particles  "disappear and reappear according to the strange laws of quantum mechanics, where everything that exits is never stable and is nothing but a jump from one interaction to another", writes  the Italian physicist Carlo Rovelli (driveby). He adds "some "elementary particles vibrate and fluctuate constantly between existence and nonexistence and swarm in space". I think this describes intraday movements on the stock market as well.

The strange behavior does not apply to big objects, or does it? Heisenberg doesn`t apply to things like cars, washing machines, TV-sets. They behave mostly predictable - even that they can break down unexpectedly. If you look on very large objects - our sun system, galaxies, the cosmos - you can exactly predict how they will behave next year or in a million of years. Very big objects follow laws described by Newton & Einstein and not by Quantum Physics.

What we can learn from that?  Stock market movements can be interesting in the short run - and sometimes thrilling - but they are of no use for investment decisions. But Heisenberg doesn´t apply to long term trends. Investors do well if they ignore the random & noisy short term moves. The University New York calculated that since 1928 the US stock market (S&P 500) created an average return of about 10% p.a (dividends reinvested nyu.edu/ investopedia). So, investors with patience and a long term horizon get plentiful rewarded for the daily risks and the stress caused by all the noise.

PS  For illustration I used a painting by Jackson Pollock, called "Autumn Rhythm", which seems to reflect the random behavior of particles & stock markets.

3 comments:

  1. This is an interesting comparison and I enjoyed it very much.
    I would like to make two comments.
    First, as in physics, it is the transition from the very small to the very large that poses the biggest problem. I cannot imagine that short-term stock market fluctuations come and go without leaving traces. They raise fears and hopes and have learning effects that influence future investment decisions. New opportunities arise while some options become no longer available. This is a complex world in which the patterns of different periodicity – of daily and hourly and even shorter times - arise and overlap with longer-term movements. Their interaction determines the dynamics and long-term path of the system in a way which may not allow investors to analytically separate the short term from the long term and to “ignore the random & noisy short term moves”.

    Maybe, you would like to have a look at some of my posts tagged ‘complexity’, where I elaborate these and other ideas in greater detail:
    https://reszatonline.wordpress.com/tag/complexity/

    My second point is that your investors need much patience – and may fail anyway. I wonder how the results of the University New York study you mentioned would have changed if the authors had chosen a different time period. Would investors who started or ended earlier or later have benefited from a similar average return? Would an investor – no matter when he lived in the last one hundred years - have had a realistic chance to get a comparable return in his life time?

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    1. thanks a lot for your thoughtful comment. I will think about it, maybe it will inspire me to write a more elaborate post about this issue sometimes. I will certainly ready your complexity studies.

      To point 2: There are studies with a lower return - maybe 7% p.a. (each with dividends reinvested) - which are nice enough. And the long term charts (even without dividends)look encouraging. In the recent decade - including the 2008 panic - the S&P 500 gained 5 p.a (this index ignores dividends).

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    2. I also believe that even crashes don`t really matter http://drivebycuriosity.blogspot.com/2016/03/stock-market-crashes-are-so-overrated.html
      and what happened with the flash crash from 2010?

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