machines vs. humans

…a financial Industrial Revolution?

I remember reading, years and years ago, an analysis of changes in the nature of work that happened during the Industrial Revolution.  The general idea is that, say, candlesticks had been made as one-of-a-kind items, out of precious materials and ornate decoration, worked for months by an artisan who had spent years learning how to do this.  Yes, the end product was useful, but it was also very expensive, meant for a niche audience, and acted as a sign of the owners’ superior wealth, taste and privilege.  In contrast, the “new” candlestick was made, fast and cheap, out of ordinary stuff, by a guy who knew how to operate a machine.

Today we find it hard to imagine the possible appeal of most pre-IR objects.  Yet they were once the norm.

 

The macro/microeconomic research-based stock market investment reports of the kind I used to create were made by people, like me, who served long apprenticeships under masters of the craft.  The work tended to only start to approach minimum standards after the author had, say, five years of practical experience in an investment management firm.  Buy-side portfolio managers like me also used the voluminous output of internal or brokerage house analysts who spent their careers studying a specific industry group.

By 2019, most of the experienced buy- and sell-siders have either retired or been laid off,  and have been replaced in many cases either by computer-controlled index-tracking products or by algorithms.  The main forces in today’s daily stock market trading have become machines, some programmed to carry out the wacky theories of the academic world, others to react to signals from the patterns of trading itself (i.e., technical analysis) or to news stories (typically written by reporters trained mostly as writers) or to extrapolate from the patterns of past business cycles.

progress or free-riding?

Are the research reports of a decade or two ago analogous to the candlesticks of the Pre-IR era?  Are algorithms like early industrial machines?  Are they a better and cheaper, although different, way of dealing with financial markets than having a very expensive group of human craftsmen?  Does this mean those who decry algorithms are simply Upper East Side-dwelling Luddites?

I don’t know about “simply.”  My feeling is that algorithms are here to stay.  And my experience as an investor is that it’s very dangerous to think that just because you don’t like or understand something that it serves no purpose.

Still, my suspicion is that as it stands now, there’s a healthy dose of free-riding to algorithmic trading.  In other words,  it looks to me as if some algorithms rely on reading the signals of human professional investors as they move in and out of stocks in response to their research findings.  As those humans are displaced by machines, however, those signals will disappear–implying algorithms will have to evolve if their raw material is to be something other than random noise.

 

 

 

 

 

 

3 responses

  1. You make an interesting analogy – it is too early to tell and, like you, I suspect that there is a lot of free-riding (trend following) going on. We will see as the trend changes (I think we are starting to see the beginnings of a trend change over the last 12 months).

    • Nice to hear from you. Hope you’re doing well. I took an investment banking course in business school that was lectures by prominent people in finance. One session was a bond panel. There were several older men from big bond houses and a brash young guy from Drexel. The Drexel guy stood up and said the others just sat in their clubs and clipped coupons. They knew nothing about credit analysis, they mispriced weak-credit bonds terribly, and he was picking their pockets every day. The others harumphed, but that was when junk bonds were only fallen angels. Yes, Mike Milken did eventually become a major financial criminal, but it was the beginning of a new era and the establishment wasn’t listening.

  2. Pingback: What stocks to invest in = machines vs. humans « PRACTICAL STOCK INVESTING | Stock Investing

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