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Risk Management

Traders Should Stay Ahead Of Academic Research

Academics have tried hard for many years to convince traders that they cannot profit from randomness. This has negatively affected markets by lowering liquidity and surrendering exchanges to robots and algos. This biased view is also partly responsible for the formation of bubbles since passive investing now dominates.

This is another bias the academic community suffers from but it has helped in generating a large volume of journal papers and in securing tenure credits for a large number of professors.

People with no skin-in-the-game have managed to convince traders that they cannot profit from the markets because they are random. But science still does not understand well the notion of randomness and even that of probability. Despite that, these dubious notions have found a perfect place in the finance field where almost no experiments can be replicated.

The academic community serves primarily its own interests that include secure, high salary jobs with a few hours a week teaching in comfortable environments while the average worker in the USA stays in office or field more than 10 hours a day with high level of job insecurity.

Possibly, the results of more than 95% of academic papers cannot be replicated. It is disconcerting that papers with look-ahead bias about price series momentum and trend-following have passed peer review. Traders should do themselves a favor and ignore the bulk of academic literature that purports randomness and listen to experienced traders and professionals in the field with skin-in-the-game and above all concentrate on learning how to trade.

The dramatic decrease in the number of active traders in the last two decades is partly responsible for the collapse in liquidity and bubble formations. During the dot com bubble the population of traders was about an order of magnitude larger than it is nowadays and that possibly prevented amplifying the irrational exuberance and an even larger correction.

The rapid decrease in the numbers of human traders is part of the reason we have already experienced flash crashes and there are more to come. The ramifications of the relentless effort by the academic community to remove humans from trading will soon become evident. The human market maker and specialist provided a shield against the effects of randomness at the cost of limited corruption. The switch to HFT as a market maker will turn randomness into a self-fulfilling prophecy to vindicate those who in the first place promoted the idea. Some professors will get a Nobel Prize while many investors will lose their life savings. The choice between some level of human corruption and unpredictability has been made by the academic community where people with little or no understanding of the markets, save the gross misunderstandings, have been elevated to authorities.

Then, another disconcerting fact is the crowding effect from academic research discussed in this article. Investors pay too much attention to the results of academic research and adopt the strategies. There is a negative effect on alpha after strategies are published.

Overall, the increase in the volume of academic papers about trading strategies and the markets in recent years poses threats to both markets and hedge funds. The bulk of the underperformance of hedge funds may be related to that. As I have written in another article, hedge fund managers should try to stay ahead of academic research. This involves among other things protecting their strategies from people who are connected to academia because one day the strategies may become public.


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