Sunday 30th April, 2006

 

Chaos theory can guide stock choices

 
 
 
 
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It has been said the stock market is a place where people who understand make a lot of money from people who do not understand.

Artificial Intelligence

There is new artificial intelligence software in use by stock analysts, called neural networks. This is based on the idea that financial systems mimic the human brain. Its focus is to capture an array of data on the day’s closing prices, trade volumes, highs and lows, across several markets, globally.

The software then plots the trends and offers forecasts on the input market data. It mimics the human brain by virtue of the vast amount of inputs that can be accommodated every second, every minute and still result in an interpretation for a course of action.

It is superior to the traditional forecast methods from the point of view that like the human brain it can also render an interpretation of inputs that do not make logical sense, or data that is incomplete. The system will still spit out the best, reasonable course of action.

This is how the human brain works!

Chaos Theory

There is another artificial intelligence system in use by stock analyst, based on physics and mathematics, called chaos theory. In a nut shell, the system interprets trends based on physical laws that predict that every system of order will proceed to a state of disorder.

Its usefulness lies in the belief that the so called disorder is governed by a set of rules and laws. The challenge for the stock analysts is to uncover the set of rules in the state of chaos.

The order in the stock market is seen in those times when people sell because stock prices, are falling, and the prices continue to fall, primarily because people are selling off stocks, in a market where none or few are buying.

Conversely, people buy when prices are rising, and because they are buying, prices continue to rise. Then drama happens, the order begins to agitate and chaos results. This leads to a state of inaction and chaos is the order of the day.

But something will happen to start a new trend.

Genetic Coding

There is yet anther model based on biological systems, it is called the genetic algorithm. This is based on the concepts of evolution: mutation, genetic coding and survival of the fittest.

Founded in computer science, genetic algorithms have their origin in a search mechanism for optimal searches that lead to the best approximate results. Behaviour in the system is charted on the basis of experience, such as the learning that goes on in a living organism, based on memory and recall.

Stock analysts are using these new systems to make more accurate forecasts, about how the market will behave the next day, or over the next period.

The question we need to ask ourselves is: what happens when everybody is doing the same thing? If we are all following the same stocks what is the opportunity to move first? Certainly if the market is fairly efficient, we will all move at the same time, and maybe only a few will be ahead of the bottleneck.

Therefore, I am forced to conclude it is the people who understand the market better than the rest, who can make the most rapid, and the most efficient move.

Outside of that, what is the chance of making good gain, from following those stocks that nobody is watching?

There is another concept called the “neglected firm effect” for people who really want to be among those who truly understand.

Continued next week

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