As long as you cannot predict an event, it is considered random. However, is it true? What makes something be really random? The absence of a specific pattern? The inability to predict what the next event will be?
Humans have an almost uncontrollable desire to find patterns in things. Our evolutionary process has guaranteed our brain as a fantastic tool to classify things: from recognizing the face of your mother from the time you are born to knowing who you can trust or not (!?)
Regardless of what we have learned to classify or not, the big point is that we are too bad at dealing with the lack of patterns. In the post "Predicting Rare Events and Financial Crises" we left open the question "how to calculate the probability of the occurrence of 17 heads in a row if this never happened in your sample?
Do you think throwing a die or shuffling a deck are random events? Maybe not. The act of rolling a die is ruled by specific mathematical laws and if we knew precisely the rolling force, the direction of the wind, the friction with the air, initial position of the die, the throwing angle, the point of friction with the surface and all the other variables involved, it would be absolutely possible to predict what the outcome of the launch would be. The same rational can be applied to a deck or trading. So, possibly, randomness does not exist - and not even the free will - since everything is the result of a combination of previous events, and changing any one of them, lead us to have a totally different answer.
Any change in the initial conditions of the die will influence the final result. Stopping to look at a bird can prevent you from being hit by a car a few minutes later or make you to meet the love of your life - the famous butterfly effect. If things are like this on a daily basis, why would they be different in the financial markets?
When looking at a chart of any asset, the first thing that happens is to fall into the temptation to find a pattern in the prices. As our brain is a beautiful classification machine, we can find several of them already in the first 5 minutes looking at the chart ... we still have the ones who say: if you look at the chart and in less than 1 minute you find nothing, it's because there's nothing to be done! In fact, it is very easy to look at an already drawn chart and find a lot of things that "seem to have happened since others have happened," or better saying, the famous patterns of the technical analysis. What is really difficult is to find these same patterns live, in real time, while the chart is forming. Here is where the "men are separated from the boys".
Everything that happened in the past chart was a consequence of past events and events that no one would even know would happen, others already partially expected and all the consequences of the others - remember the butterfly effect described above. Everything that will happen from this second will still be influenced by the speed of response to the events that are happening now, what other people are seeing on the same chart and the consequences of other possible infinite variables. Any change in price now influences the present so much that forecasting what will happen in the future is practically impossible, assuming that we do not know all the variables involved.
This discussion brings us closer to chaos theory, as defined in one sentence: systems considered to be dynamic are extremely sensitive to their initial conditions. A personal example: one of the reasons for the 2008 financial crisis was the near-zero US interest rate cut by the Fed Chairman Alan Greenspan, to contain a chain effect caused by the dot-com crisis, the internet business bubble. The crisis of 2008 led the job offers and wages in the US to a huge reduction, a fact that made me choose another place to do my internship. This "new" place was close to a mountain region where I went one day to ski for the first time and I broke my knee! In other words, would I have broken my knee because of the dot-com bubble?
Anyway, does randomness exist or does not? Like everything in life, it depends! By the point of view of the classical physics, no...while by the point of view of the quantum physics, yes. The subatomic universe is completely different from the Newtonian physics. With all this talk of randomness, classification and cause-and-effect relationships, we leave an open question for the next post: Is technical analysis a fallacy?
Rare events are by definition events that happen with a very low frequency. Frequent examples of the literature are large tsunamis, earthquakes and the impact of an asteroid. However, the rare event to us is a financial crisis. Rare events exert so much fascination not because they are rare but also because they are difficult to predict, making whoever does it - by luck or not - the next great guru for a few months or even years.
I intentionally used the term "luck" because according to the efficient markets hypothesis, any financial crisis is practically impossible to be predicted, being practically impossible to make money trying to predict what will happen next in the markets. Consequently, when you get it right, it's nothing more than a coincidence of facts.
An interesting point here is that perhaps will never be possible to predict exactly when a crisis will happen, but it is possible to understand that a crisis is imminent with a certain degree of probability - which always brings us a certain degree of uncertainty as well. The problem lies in ignoring the degree of uncertainty and finding that only a high probability is a "guarantee" of occurrence of a particular event. Toss a coin 100 times gives you a high probability of a certain amount of "heads" happening - close to 50% - but nothing prevents you from having 100 "tails" in a row. Okay, it's rare, but nothing says it cannot happen.
Let's do a practical test. Check on the chart below the results from a 1000 coin tosses simulation.
A simple simulation of tossing a coin 1000 times, using Microsoft Excel (for the sake of the argument, lets forget questions such as if the RAND function is random and what is randomness), shows us in the following chart an idea of what can happen. In this example, in 1000 "tosses", a sequence of 15 heads (maximum value in a row obtained) occurred 2 times and in 16 times we had a sequence greater than 10.
What do we conclude from this, and what does this have to do with investments or trading?
The first point here is the fact most ignored by the beginners: "this stock has already gone up too much, it has been going up for 10 days ... it will go down, for sure". As we saw above in the coin toss example, if the coin were an stock share and the "head" was a bullish day, we saw that the stock would have gone up "15 days in a row", twice in a period of 1000 days. And we cannot forget that we had 16 times with more than 10 hypothetical bullish days.
This leads us to the second point: is it possible to profit from this? Yes, but never neglect the fact that we can perhaps have one single time 15, 20, or 30 heads in a row. But don't forget that your risk:return ratio, that is, how much your bet is worth is more interesting every time. It is guaranteed? Never will be...especially if the events are independent, like the toss of a coin ... but in markets, where everyone will probably be "seeing" the same event and trying to anticipate what will happen, we have the effect of the self-fulfilling prophecy. This would prove once again the efficiency of the markets and the impossibility of predicting it. One may try to predict something...but taking this guy seriously is another talk.
Finally, the third and final point is that crises are impossible to be predict, since they are examples outside of any sample - outliers. They never happened before, so it would be impossible to try to predict what never happened...it would simply be impossible to calculate the probability. Returning to our example of the 1000 tosses, how to calculate the probability of occurrence of 17 heads in a row if this never happened before?
Lets wait for our next posts!