Even Brilliant Mathematicians Cannot Beat the Market. What Chance Does an Amateur Investor Have?
The other day, I heard an interesting story while watching a discussion between financial experts.
One of the guests had worked as a quant at a major bank. Quants are specialists who use advanced mathematics and statistics to analyze financial markets.
After earning a doctorate in particle physics, he moved into the financial industry.
I also studied particle physics in graduate school. He was at a completely different level from me, since I stopped after my master’s degree, but I still felt an odd sense of kinship.
The mathematics and simulation techniques used in physics are well suited to financial engineering. Experts in mathematics use them to compete for profits in financial markets around the world.
When you think about it, that is a frightening arena.
Can an Amateur Beat Professional Mathematicians?
One part of the discussion that stayed with me was the story of the hedge fund Long-Term Capital Management, or LTCM, which involved Nobel Prize-winning economists.
LTCM generated profits using sophisticated mathematical models, but it suffered enormous losses during the 1998 Russian financial crisis and was effectively driven into collapse.
The interviewer asked:
“If even a model created by researchers that brilliant can collapse, is financial engineering really useful?”
The former quant’s answer was interesting.
Under normal conditions, he said, mathematical models work extremely well.
They analyze patterns in the market using enormous amounts of data and advanced mathematics, then accumulate small profits. Can an individual investor really expect to defeat such teams of specialists using intuition alone?
The discussion also mentioned that most actively managed funds fail to beat the market average over the long term.
If even professionals struggle to do so, it is even more difficult for individual investors.
That was why the former quant recommended index investing.
Instead of trying to beat the market average, you buy the market average itself. You avoid competing with professionals and participate in the growth of the market as a whole.
It is an unexciting conclusion, but it is persuasive when it comes from a professional mathematician.
Then I Wondered: What Happens When the Model Breaks?
From this point onward, these are my own thoughts.
Mathematical models perform best in a world where certain assumptions continue to hold.
In reality, however, wars and political upheavals occur. LTCM suffered enormous losses when the Russian financial crisis destroyed the price relationships its models had assumed.
The mathematics itself was not necessarily wrong. The world assumed by the model had become different from reality.
The same is true in physics: a model can be used only within the range where its assumptions hold.
Financial markets are even more troublesome. Their participants are not particles obeying natural laws, but human beings driven by fear and greed.
Mathematics cannot calculate what the leader of some country might suddenly say tomorrow.
That made me wonder:
Even if individual investors cannot beat mathematical experts under normal conditions, might they have a chance when the mathematical models stop working?
Do Amateurs Have a Chance Precisely When Professionals Cannot Win?
During a financial crisis, markets can panic, and stocks and bonds may be sold at prices that would normally be unthinkable.
Could an individual investor jump in and seize the chance to make a fortune?
The possibility certainly exists. But so does an equally large possibility of suffering a disastrous loss.
Just because professional models no longer work does not mean that an amateur’s judgment suddenly becomes correct.
If professionals do not understand what is happening, amateurs understand even less.
You may buy a collapsing stock because it looks cheap, only to see it collapse even further the next day.
Some people will undoubtedly make fortunes as a result. But if the result cannot be reproduced, it looks more like gambling than investing to me.
Individual investors do have a chance to become rich overnight. The catch is that the opportunity appears precisely when even geniuses no longer know what will happen.
In the End, the Boring Conclusion Is Index Investing
After thinking it through, I find myself returning to the former quant’s conclusion.
Under normal conditions, participate in the growth of the market through index investing, and do not panic and trade during a financial crisis.
If you absolutely want to chase a windfall, participate as a gambler using only money you can afford to lose.
Because I know at least something about the world of mathematics, I have no desire to challenge financial professionals head-on in the market.
After hearing this discussion, I wondered whether amateurs might have a chance precisely when mathematical models stop working.
But when I thought more carefully, I realized that I had no basis for believing I could take advantage of that opportunity.
Geniuses run their calculations and still cannot beat the market, while amateurs challenge it with nothing but intuition.
Calling it investing makes it sound intellectual, but what they are doing is not very different from a guy betting at the racetrack.