Humans Have an Essential -- Though Small -- Role in Markets
I recently participated in a debate among hedge fund risk managers on a panel titled “This house believes that qualitative and human elements in investment are redundant.” 1 The premise was to have three speakers agreeing with that resolution, and three disagreeing. But instead of two distinct sides, it quickly became apparent that each of the six participants had a different opinion. In order from “Most For” to “Most Against,” 2 the arguments were:
- Humans should lie on the beach while computers run the financial system.
- The only role for humans is to pull the plug if computers screw up.
- Humans will account for only 1 percent of the investment process in the future.
- Humans have an essential small role in investments (that was me).
- Humans beat computers at things like negotiating restructurings.
- Computers are only a tool used by some humans.
I base my position on three facts and two speculations.
- Your unconscious brain is far superior to the best computer. The most sophisticated computers have only recently learned to tell dogs from cats in clear, still pictures; and only most of the time. Your brain effortlessly parses a confusing visual field in real time for thousands of more difficult distinctions while simultaneously doing the same for other senses and internal processing, with virtually no important errors. And no one taught it how.
- Your conscious brain is far inferior to the worst computer. It quails at multiplying two three-digit numbers. This is why your unconscious brain gets the important jobs, like regulating your body and deciding when to fight and when to run, while your conscious brain hums advertising jingles and wonders which celebrity marriages are in trouble.
- You make most -- possibly all -- decisions before your conscious brain is aware of them or has been consulted.
- (Speculation) Consciousness evolved not to improve decisions, but to explain them after the fact to other humans. If your paleolithic ancestor killed Og to get his food or mate, that would make him unpredictable and dangerous to the tribe, and might result in his murder or banishment. He would be treated like a dangerous wild animal. So he evolved a conscious brain to say -- and believe -- “Og blasphemed and I sacrificed him to appease the anger of the Gods.” The tribe might or might not accept the plea, but consciousness was like a lawyer to negotiate the consequences of decisions and promote predictable social cohesion.
- (Speculation) Computers will soon surpass the unconscious brain in making investment decisions thanks to advances in machine learning, better understanding of human decision-making and better understanding of finance. While the brain will retain some advantages for decades, computers can process far more data much faster and cheaper with less interference and, most important, will be designed and evolve for financial objectives.
It is the weak human conscious brain that will remain essential, not to make investment decisions, but to explain them after the fact.
Until we entrust the entire financial system to Colossus or Skynet, institutional investors, fund managers, dealers, regulators and other entities will have to coordinate. Currently that process is mediated by trust and human legal machinery.
Humans will have to invent new ways to explain the actions of their computers, so that other market participants can predict and trust them enough to allow trading. To date, computers have not done well at this task, while your conscious brain has been honed by millions of years of evolution to explain decisions it does not understand. It’s not much of a change when those decisions are from an external black box rather than an internal unconscious brain.
This is not a trivial task; it is difficult and essential. No human or computer has much idea of what an optimal set of prices should be -- if there even is one. The financial system exists to set consensus values on things no one knows how to value, so the economy can move forward in an unpredictable world. It would be nice if these values were accurate, 4 but it is essential that they are fair. People will only entrust their savings and their businesses if the game is not rigged. Until computers learn fairness, or the human race abandons the ideal, humans are essential in the investment process.
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The debate was sponsored by Risk magazine. Stuart MacDonald of Bride Valley referred, with Rayne Gaisford (Folger Hill), Bob Savage (CC Track Solutions) and Efrem Sternbach (Paulson) For and Thomas Zucosky (Discovery), Amy Wierenga (Blue Mountain) and me Against.
I won’t identify the positions with the people, because these are my quick summaries of my understanding of their positions, not necessarily how they would describe their views themselves.
So when a computer loses 50 percent of the asset value it controls and causes a flash crash, there will be humans around to say -- and believe -- “The computer anticipated and prevented a Black Swan that would have caused greater loss and disruption.” Other participants may or may not accept this plea, but without a defense the computer would have to be shut down. If computers are shut down every time they do something hard to understand and apparently bad, they will soon be eliminated from the financial system.
Fischer Black famously defined an efficient market as one that got prices right within a factor of two some 90 percent of the time. I told him he should write half the time and almost convinced him. He was a guy who really cared about precision even in broad brush statements.
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