Monday, February 14, 2011

Time Horizons: Data Processing

In the comments, Nadezhda linked to a post that linked to this paper -- "Heterogeneous Gain Learning and the Dynamics of Asset Prices"

The very basic gist of the paper, once you cut through the math, says this -- broadly speaking, there are two types of people in the market, buy-and-hold types and traders. Buy-and-hold types, however, don't have much influence on prices despite having the most money in the market. It's the traders that drive price fluctuations. So, then the question is, what drives the traders? The authors break up traders into two categories -- technical traders (those who look strictly at stock price trends) and fundamental traders (those who look at the metrics that ought determine the value of a stock). Thing is that these traders overemphasize recent data, and since they punch above their weight when determining prices, the market overreacts to recent data.

That's all pretty obvious, in FLG's opinion. But then FLG thought of another paper he read a while back "Constructing the Market Frame: Distributed Cognition and Distributed Framing in Financial Markets:"
The data available to professional actors in financial markets is overwhelming in quantity, and no individual or organisation can comprehend its totality. Selectivity in cognition is thus unavoidable. What is selected, and who or what influences that selection, are thus potentially matters of considerable importance.

FLG thought to himself: Imagine that we all possess differing, but ultimately fixed ability to analyze anything. This means you have to make a choice about what to analyze. You can either look at the long-term, do your homework, and take a buy-and-hold strategy. Or, you can look at the most recent data and try to make short-term profits. That is to say, you can either look at the forests or the trees, but not both. However, given the nature of today's interconnect world, new information is flying at traders. So, it's not even like the forest or the trees, but more like speeding through Endor on one of those speeder bikes.

Thus, the traders develop short cuts. They rely upon investment bank analysts, who it probably doesn't need to be said have a conflict of interest Chinese Wall or no, and rules of thumb, that may or may not be correct. To continue the Endor metaphor, these guys are speeding by getting radio reports from somebody saying that the tree that want to sell is great while blasting through the forest making judgments about the quality of the tree based upon the thickness of the trunk and color of the bark.

FLG, do you have a point in all this? No, not really. Just liked the Endor metaphor.

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