Perspectives from ISB

Co Author: Khemchand Sakaldeepi; This article was first Published in Hindu BusinessLine on 25th November, 2012

While taking a hard look at the evolution of human civilisation one cannot help but notice how the financial markets indicate our evolution more than anything else.

To quote Prof. Niall Ferguson of Harvard University, in his book “The Ascent of Money”, financial history is the essential back-story behind all history”.

It is a well know fact that every bull – bear run is largely correlated with something major happening in the world.

The invention of electricity, use of small motors that power home and kitchen appliances, the advent of television and computers, etc. have all impacted how financial markets behave. These events have changed how the world is connected and does business, for good. Today the biggest driver in the way we connect and do business is social media.

Any student or practitioner of finance would have come across the term “Efficient Market Hypothesis (EMH)”. It essentially says that the stock market is “informationally efficient”, that is, the current prices reflect all the available information. Flow of information is one of the most important ingredients in making the markets efficient.

While EMH is one of the most profound theories in the history of finance, of late, it is also the most disproved.

The recent global financial crisis has further raised questions about the rationality of the EMH. Warren Buffet argues that the preponderance of value investors among the world’s best money managers rebuts the claim of EMH proponents.

Similarly, former Federal Reserve Chairman, Paul Volcker said that it’s “clear that among the causes of the recent financial crisis was an unjustified faith in rational expectations [and] market efficiencies”.

In fact there are many investors who scout for opportunities (read: inefficiencies) with the changing business environment and capitalise on information advantage.

Traders at Wall Street are known to use Flash Trading – which allows certain market participants to see incoming orders to buy or sell securities very slightly earlier than the general market participants, typically 30 milliseconds, in exchange for a fee.

Lately, some of the major financial institutions are latching onto the fact there might be something to the information that is available in social networks such as Facebook, Twitter, Blogging sites, etc.

For instance, a research done by Bollen et. al. (2011), published in the Journal of Computational Science, looked at around ten million Tweets posted between March and December of 2008 to see if the micro blogs could be used to predict the market.

The authors sorted the Tweets into different indices – calm, alert, sure, vital, kind and happy – and compared them to the market. The researchers found that the calmness index can predict with 87 per cent accuracy whether the Dow Jones Industrial Average goes up or down for a time horizon between two and six days.

Certain proprietary terminals have, over the past few years, kept various traders informed with live new feeds. They, however, have not come close to creating a way to instantaneously monitor the pulse of the world and observe the stream of human consciousness. The news regarding the death of Osama Bin Laden first entered the public sphere through a tweet and a tool called DataMinr was able to spot this with just 19 tweets on the subject.

The company then issued a signal to their clients, alerting them to this important piece of information. It would have been over 20 minutes before that story appeared on traditional news sites.

Access to a data stream that can beat traditional media sources by over 20 minutes requires no explanation as to its value for traders and investors. Speed matters.

It will just be an understatement to say that there will be an increasing relation between social media and finance. Traders and fund managers are relying on social signs and sentiment analysis to base their decisions on.

There is no doubt that technologies are improving and challenging the finance and banking industry. In the language of Analytics, the more data you have the better your decisions are and better is your competitive advantage. And social media can do just that.

So the point to note here is that in this era of Social Networks, it has become essential for any budding investor to be able to analyse the social data if she/he wants to “get the pulse of the market”.