The faulty narratives driving asset markets

An estimated 75%+ of global market transactions are now driven by algo-wielding computers rather than humans. Moving at lightening speed, buy and sell orders trigger on data flow and headlines ‘fake’ and not.

The prevailing thesis held by many, is that market prices are always right, and markets driven by machines are smarter and more right than ever before.  And therein lie the seeds for great financial harm.

Contrary to popular assumptions, algorithms suffer from the same ‘garbage in garbage out‘ bias errors that plague their human creators.  Just as central bank members employ faulty models that never see financial bubbles or mean reversion cycles coming, most trading algos suffer from similarly selective assumptions.  See: Algorithms and bias, for a informative discussion:

In an algorithmic system, there are three main sources of bias that could lead to biased or discriminatory outcomes: input, training and programming. Input bias could occur when the source data itself is biased because it lacks certain types of information, is not representative or reflects historical biases.

Training bias could appear in either the categorization of the baseline data or the assessment of whether the output matches the desired result. Programming bias could occur in the original design or when a smart algorithm is allowed to learn and modify itself through successive contacts with human users, the assimilation of existing data, or the introduction of new data.

I recall having similar revelations as a young law student 27 years ago, when it became apparent that judges were humans and not the objective, fact weighing and law applying machines that our legal system assumed them to be.

All of this is relevant context to discussions like the one below on CNBC yesterday.  Note the host countering with the supposition that markets trading on headlines must be in the know.  Fascinating chapter in human history this.  Whatever the current preoccupation may be–gaming, gambling, speculation–it certainly does not belong under the seemingly rational heading of ‘investing’.  And there is the rub, because so many people have their life savings in this game not realizing the true nature of the activity and the horrendous odds they have taken on.

Francesco Filia, CIO of Fasanara Capital, told CNBC on Wednesday that financial markets had become “complacent” and “insensitive” to fundamental changes in the economy. Filia cited “Stein’s Law” as a fitting adage for the state of financial markets at present. Herbert Stein, chief economist to U.S. President Richard Nixon wrote: “If something cannot continue forever, it will stop.” Here is a direct video link.

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