Thursday, May 25, 2006

Dumb Agent Theory

This is the theory that my thesis is based on. It is a theory that has been observed time and time again, although never proven per se. I am applying this theory to a future’s market, which I believe can be used as an indicator; in my case, for Foreign Direct Investment.
Right away I will say that this theory, being unproven, could be seen as rather tenuous to base my whole thesis on. It would be as if I had constructed an instrument capable of saving the Roman Empire based on the theory of Time travel. On the other hand, many occurrences, especially in physics, have been based on theory. The most prominent example is gravity, which comes about basically through process of elimination. Although this is all we have in theory, we have seen it in practice many times, and many other theories are based on it, such as observing the gravitational pull of stars in order to determine the position, size, mass and movements of planets that cannot be seen. That is why I treated this theory as such. Since it has been observed time and time again in many markets, and has never been shown to be incorrect, I assumed that it was correct.
Lately, however, I’ve been wondering if this is wise, so I decided to delve into the theory behind what happens to see if I can make sense of it.

The basis of any market, is the value of the underlying object or entity, or, more precisely, its utility. The difference between these is that an object could have an underlying value that is never utilized/observed/understood etc. I won’t get into whether something can be of value if it serves no purpose since that would bring me down a philosophical road I won’t know the first thing about. I will say that the value of any object or entity is its utility.

So, let’s take Object Alpha. Alpha has a utility, and therefore a value, of X. Can we guess what X is? If I were to guess I would probably say a number that is too high or too low. If any other person guesses, he or she will have the same results. How can we correct this? Well let’s take the other extreme: If everyone in the world guesses, values will be all across the board. But there will be a mid-point (or equilibrium point, or an amassed perceived value). This point must, by definition, equal Alpha’s value. If everyone estimates its value based on their perception of its utility, the amassed perceived utility must equal its real utility.

This follows along the lines that if I were the only person who could ever possibly achieved any utility (be it positive or negative) from Alpha, my perceived utility would indeed be its value. Therefore, everyone in the world together would be able to discover Alpha’s real value. So one person could achieve any value for Alpha, while everyone in the world would achieve its true value. In fact, everyone that gets any form of utility from Alpha would, collectively, be able to find its true value. Following this theory we can see why more liquidity means more preciseness in determining Alpha’s value, which basically proves the theory.

But what still bothers me is, if this theory can be shown to be true, why isn’t it used more often? I know companies have started using it, especially hi-tech companies, in order to determine what trends will last or pass away. How could one know ahead of time how big the I-pod would be, or how wireless keyboards would not pick up at all? It is also being used in order to predict outbreaks of influenza (I use this as a case study in my thesis) and has been shown to work well even with a very small number of traders. Maybe, like any idea, it just needs to have its time. When a market was proposed where people could trade on likelihood of a terrorist attack the Policy Analysis Market, the idea was immediately crushed in the house and the pentagon had to get rid of it. I still don’t understand why.

Anyway, if anyone has any thoughts, comments or constructive criticisms please let me know as I’d like to know this stuff backwards, forwards and sideways.