Probability theory is all well and good at the casino but largely ineffective when dealing with the stock market, professor of experimental finance Peter Bossaerts says.
The reason, he says, is that while the “quant guys” are crunching numbers based on a level of certainty, the finance world is too nuanced and uncertain for us to know what outcomes will eventuate.
“The finance guys have been thinking about uncertainty as if the outcomes from the stock market look like the outcomes from a roulette wheel,” Bossaerts explains. “When you throw the little ball it can land anywhere, but if you do it over and over again you know what the chances are that it will land on red or black. It’s standard probability.”
Bossaerts, who is a decision neuroscience honorary fellow at the Florey Institute for Neuroscience and Mental Health, says these traditional ways of thinking result only in machine learning.
“When you look at the guys in computer science and mathematical finance – the engineers of finance – they treat the world as if the stock market were a slot machine,” he says.
The academic believes that instead of trying to figure out the mathematical probability of a scenario coming to pass, we should be taking the Warren Buffett approach.
Buffett doesn’t “flip a coin and hope it comes up heads more than tails”, he says. He looks at a company valuation like a complex problem.
“Buffett rearranges companies and tries to maximise their value,” he says. “That view is fundamentally different than the view the quant guys have.”
The issue for investment professionals is that they aren’t Warren Buffett, and while countless investors have tried to mimic his judgement, Bossaerts makes a concerted effort to translate the Buffet way of thinking into a standardised method.
“What I’ve done is formalised the way Buffett thinks,” he says. “Just like the quant guys formalise the way they think using probability theory, I’m formalising what people like Buffett do, but in mathematical language.”
Bossaerts says the language he uses in his work is “the language of computer science and complexity”, and likens it to that of Alan Turing, the computer scientist portrayed in the movie The Imitation Game.
“Turing was the one who started thinking this way,” he says.
Bossaerts will be a speaker at the 2018 Portfolio Construction Forum Strategies Conference, to be held at Carriageworks in Eveleigh on August 22-23.
This year’s forum will feature 45 investment thinkers from around the world debating contemporary and emerging portfolio construction strategies in the context of the thematic question, “Are future-proof portfolios achievable?”