If you’ve seen the movie The Social Network, you probably heard the word “algorithm” thrown around. A lot. Most of the people who were getting rich in that movie seemed to be busy doing nothing but being super smart, and writing lots and lots of algorithms.
In the financial world, on the other hand, algorithms were one of the main catalysts behind the 2008 meltdown in the U.S. mortgage market. So why do some algorithms make billionaires out of the founders of Facebook, while others cause multinational banks to lose trillions of dollars virtually overnight?
The answer lies with data streams. If you have a stream of data that’s predictable (which is to say, data that isn’t random), you can write an algorithm that compresses that data into a repeatable instruction, and then use that algorithm to process an unlimited amount of future data. As long as the pattern isn’t random, the algorithm will work against even the most complex problems. The better the algorithm, the less room the data takes up, and the faster and more effective it becomes.
Now, I wouldn’t know an algorithm from an Allen key if one came up and bit me. But algorithms are a huge part of our lives, from every phone call we make to every picture we post on Facebook. Yet for all their mathematical might, algorithms only work with non-random numbers. And when it comes to markets, no matter how much we might wish otherwise, there’s absolutely nothing non-random about them.
In 2008, banks were using faulty algorithms to quantify the risk on the huge pile of sub-prime mortgages that were being tossed back and forth like poker chips from one financial institution to another. By the time they woke up to the fact that they were dealing with exactly the kind of non-random data that algorithms can’t predict, it was too late. The bottom had already fallen out of their game of musical chairs, and thousands of people lost their homes and life savings as a result.
In the stock market, we often have a tendency to fall prey to the idea that things aren’t really random after all. There are all kinds of computer programs you can buy, charts you can download, and economic forecasts you can listen to that say they can create order out of all the random forces that are buffeting the market from one moment to the next. The inherent promise they’re making is that they (and they alone) have somehow figured out a way to use the past to reliably predict the future.
The problem is, none of those things work reliably, for the same reason that caused the banks to go belly-up in 2008: since the stream of data that’s coming in from the stock markets is ultimately random, you can’t write an algorithm to predict it – just as you can’t predict what’s going to happen tomorrow based solely on what occurred yesterday.
How do we know? Because if it was possible to predict the future based on the past, someone just as smart as all those Facebook geniuses would’ve already written an algorithm to do it. And that someone would now be managing all our money.
But no one manages all the money. Even the biggest banks all offer dozens of different mutual funds, because they have no idea exactly where you should invest today to come out ahead in the next quarter. If they did, they’d just have one fund – the “right” one.
Fortunately, as an investor, all this randomness can actually work in your favour. It’s precisely because markets are random that you get paid extra for taking the short-term risk of investing in them. Also, when it comes to equities, being small doesn’t have to be a disadvantage. If you were in the algorithm business, you’d be competing head-to-head against behemoths like Facebook. But as an investor in stocks, you can beat 90% of the highest-paid institutional investors in the world just by buying a broadly diversified portfolio, and holding onto it long enough to reap the rewards.
That way, rather than wasting your energy trying to find patterns that don’t exist, you can spend your time figuring out the things you do know. Like how long you’re probably going to live, when you’re going to retire, how much money you’ll need to live comfortably, and what kind of legacy you’d like to leave behind.
Those are the real, solvable “equations” that you can actually put into a plan, and then decide how best to fund them through savings and investment. And none of them involve searching for imaginary patterns in the stars, reading tealeaves – or consulting algorithms.
Alan MacDonald an investment advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of “The Copperjar System, Your Blueprint for Financial Fitness” available on Amazon.
For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com.
All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates. Past performance is not indicative of future results.
Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.
