Investors who feel there is no good reason for their stock losses may be right, said US researchers who reported on Monday that an irrational computer model very accurately predicted activity on the London Stock Exchange. The model, which assumed buyers and sellers act with "zero intelligence," did not show that traders act blindly, the researchers reported in the Proceedings of the National Academy of Sciences.
Rather, it showed some market properties may depend more on the structure and constraints of trading itself than on a trader's individual strategic behaviour, they said.
"The prevailing view in economics about how markets function is that you have a rational investor rationally processing all the information that arrives," said Doyne Farmer of the Santa Fe Institute in New Mexico, who led the study.
"Our analysis challenges that view by saying that maybe a lot of price movement is more or less mechanical," added Farmer, a physicist who turned his expertise on complex systems and chaos theory into a business predicting markets.
It could come down to patience, emotion or rationality, he said.
"We are not saying anything about how stock price goes up or down," Farmer said.
Farmer's team assumed that "minimally intelligent" traders placed orders to buy and sell at random, subject only to trading rules in a typical financial market.
Minimal intelligence means knowing something about the price for buying and selling. "But it is something you can teach your dog," Farmer said in a telephone interview. "You can program your computer to do it in one line."
They tested their model using 21 months of data on 11 stocks from the London Stock Exchange. It did not predict prices, but it did predict, to a degree, the spread - the difference between buying and selling prices - and the price diffusion rate, how actively prices were moving around.
"As a lay investor, it might give you some insight about what is affecting bid-ask spread or volatility," Farmer said. "As a regulator it might tell you some very interesting things."
Farmer suggested the Securities and Exchange Commission could, for instance, use his model to tell whether a New York Stock Exchange specialist trader was properly controlling the volatility of his or her assigned stocks.