Sunday, November 20, 2011

the more information you have, the less randomness you see

Nick,


In a given market (say some commodity - favorite example), big players don't see randomness. They see price actions as a result of a few big players' positions and decisions. Small players (I was once trading copper, soybeans, wheat..) see randomness.

When I was a boy I enjoyed pouring various liquids into the "home" of ants -- random events to the insects. I guess some "smart ants" could record rainfall and build statistical models based on this kind of observed randomness. It gives me nightmares of building a nice-looking palace on quicksand.

Here's a gross simplification -- When we don't have the information about what move the market, we build some theory of randomness to explain it.

Another analogy - a falling leaf in a wind lands in random spots around the tree. We could build a theory of randomness, but what if the wind come from 10 powerful electric fans?

In hindsight people see nothing random in any market. This is remotely related to the 3rd part of the black swan theory. In hindsight we often know exactly who (possibly a large herd of investors) did what to create a surprise (possibly a black swan) and cause a big loss to a lot of uninformed investors. In such a scenario, the math models are not extremely useful.

"Herd" reacts to wolf howls and shepherd.

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