I’ve been following the news on the upcoming Facebook IPO. Most analysts and news makers describe the trading process as betting (in the sense of gambling). Here‘s an example. Yet, insightful financiers and economists would agree that trading and investing are not random processes. Nor is the market efficient. Where does the market thus stand?
Malkiel would have us believe that the market is a process entirely modeled by random walks. This is the Random Walk Theory (RWT) of the markets. That is, prices are randomly generated because ‘true’ news is entirely unpredictable and, thus, entirely random. On the other side of the coin, Fama promotes the hypothesis (and later an elaborated theory) that the markets are entirely efficient, i.e. informationally predictable. This is the Efficient Market Theory (EMT). Both diagonally opposing views are, nonetheless, cynical, as writer and investor Thomsett has put it. In light of Information Theory and its ultimate power at quantifying and perspicaciously studying information, I’d argue pretty much that far from efficient or random, the market is entropic.
I’ve written an introductory article to information theory and entropy located here. At a glance, entropy measures the uncertainty in a system or process of a number of outcomes (discrete or not). If the experiment has three outcomes (e.g. the price could be $3, 10 or 18), then these price levels are associated with probabilities, i.e. the probability of getting a price equal to $3 is 45%, etc. Entropy just averages the expected price. If the outcomes are equiprobable, i.e. all three prices have a 1/3 chance of popping up, then there is maximum uncertainty because one just can’t predict which of the three prices is going to pop up next. This latter view conforms with that of the random walk theory, according to which true information cannot be predicted and thus the market actors cannot know (or predict) what price levels to expect next. On the other hand, if it is almost sure that one can predict true news (information), then one would have no problem expecting price levels, given the almost total confidence in the probabilities. This is the view promoted by the efficient market theory. Both view are academically appealing, but not enough realistic to be embraced by the field actors. The latter embrace the entropic view of the market — though not cognizant of what it means — that I’m alluding to here.
The entropic perspective is simple: When one carries out fundamental and technical analyses, the average information one gains should increase. In other words, there shall be an average decrease in uncertainty, or entropy, in the system. Thus, the decision a trader or investor makes is indeed based on existing information (financial indicators in company reports, price patterns on charts, etc.) as well as possible future information (insider hints, unpublished news, etc.). As such, the predictability power increases because entropy decreases. It’s thus not truly random, but not yet efficient. It’s in between the spectrum. It’s thus entropic. Here’s a simple conceptualization of what I’m babbling on:
According to the entropic view of the market, if new information comes in and it is surprising, then the entropy tends to increase because the number of factors that affect the outcomes in the system increases. If the new information is expected, such as Greece’s exit from the Eurozone, then it won’t have much entropy (thus randomness) in current price level trends, although other factors might. In the long run, however, the system is less entropic, as moving averages reveal.
The main lesson to be learned by the entropic view of the market: Do your homework when investing! Read, read, read more and study, in order to decrease your uncertainty (which is also tantamount to ignorance in the naive sense).