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Zero intelligence. A new model suggests that decisions of stock market traders have little effect on the market.

Getting Rich--a No Brainer?

By: 
Kim Krieger
2005-02-01 (All day)
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Economists generally believe that the stock market rises and falls based on the rational decisions of stock traders, but they may be in for a big surprise. A new study indicates that even if stock traders bid randomly, the fluctuations of the stock market remain pretty much the same. The findings may help economists nail down the true forces that shape market behavior.

The stock market works like a frenetic, two-way auction, with buyers and sellers simultaneously placing bids. Modern economists imagine that stock market traders are intelligent and make their bids based on what they think a stock is worth. The volatility of the market--how big the jumps in price get--should be based on the amount of information the traders hear, goes the reasoning. More information means a jumpier market, as intelligent traders analyze the news and shift their bids around to get the best deal.

To verify this, a group of physicists and economic theorists at the Santa Fe Institute in New Mexico created a simple mathematical model of the stock market. But instead of assuming that traders would make bid decisions based on rational responses to market information, the model assumed the traders would bid at random times with random prices--a state known as "zero intelligence."

Despite the model's simplicity, its result looked shockingly real when compared with 2 years of data from the London Stock Exchange. The direction of the stock prices was not necessarily similar, but the volatility (how fast prices changed), market impact (how much the market jumped in response to a single bid), and bid-ask spread (the difference between what sellers were asking and what buyers were offering) were strikingly alike.

This suggests, report the researchers online this week in the Proceedings of the National Academy of Scientists, that it's not the strategic maneuvers of traders in response to new information that shape price fluctuations.

This study reveals just how little we know about how the actions of stock traders play into the fluctuations of the stock market, says Stephen Ziliak, an economist at Roosevelt University in Chicago.

Related sites
Abstract of study
Doyne Farmer's homepage
How the stock market works, from howstuffworks.com

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