I am reading an interesting book "A mathematician plays the stock market" by John Allen Paulos. Paulos, a Temple University mathematics professor is the author of several best sellers including "Innumeracy: Mathematical Illiteracy and its Consequences", "Beyond Numeracy: Ruminations of a Numbers Man", "Irreligion: A Mathematician explains why the arguments for God just don't add up".
Here are some nuggets of wisdom I gleaned from "A mathematician plays the stock market".
"Uncertainty is the only certainty there is, and knowing how to live with insecurity is the only security." Paulos did not tell us not to invest in the stock market. He cautioned us about misunderstanding of applying mathematics to the stock market and investing. His humorous, interesting book includes explanation of scams, psychological blindness such as confirmation bias, and examples of investment mathematics mistakes and analyses. He admits to losing a bit of money himself during the dot-com boom in early 2000.
1. Psychological blindness. Paulos quoted John Maynard Keynes who likened the position of short-term stock market investors picking five prettiest out of hundred contestants in a newspaper. The rewards go to folks who correctly pick the contestants whom they think are most likely to be picked by other readers, and the other readers must try to do the same. This is what Paulos distinguishes between "Being right versus Being right about the Market". He then gave several interesting examples of mathematics involving game theory.
Other psychological blindness include emotional overreactions - the irrational exuberance- and despair. Paulos cited unfounded financial hype and unrealistic "price targets" which influence investors by putting an "anchoring effect" number to stock price.
2. The incoherent market pundits/analysts, blog and chat room noises. Many seemingly technical analyses are fundamentally wrong. There have been data mining and faulty attempts to discover investment scheme that supposedly worked in the past. An exhaustive search of the economic data on a United Nations CD-ROM in the mid-90s found the best predictor of the value of the S&P 500 stock index was - drum roll here - butter production in Bangladesh. He reminds us of the mathematically ignorant attempt to "decode" the Bible hidden codes to show that the September 11, 2001 event was "prophesied".
Paulos, through extensive but easy to follow mathematic examples in several chapters gave strong evidence that the technical analysis of trends, cycles, supporting and resistance stock price levels, waves, moving average are ridiculous and quasi-mathematical which seldom hangs together as a coherent theory. Many of current fads are just rehash of past failed theories; the Elliot wave theory to predict the behavior of stocks was based upon the Fibonacci number sequence. He boo-booed the claim that folks have made good money using the rules of technical analysis by saying that some other folks also make money in the stock market using strategies involving tea leaves and sun-spots!
