The Economical-Emotional Duality

Similarly to the wave-particle duality, two families of forces are driving markets prices dynamics and oscillations : economical information on one side and emotional signals on the other side.

To quote Robert Shiller [1]: "The failure to recognize the housing bubble is the core reason for the collapsing house of cards we are seeing in financial markets in the United States and around the world. If people do not see any risk, and see only the prospect of outsized investment returns, they will pursue those returns with disregard for the risks.Were all these people stupid? It can’t be. We have to consider the possibility that perfectly rational people can get caught up in a bubble." This is for Shiller and the behavioral finance analysts a consequence of an "informational cascade": a situation where people observe the actions of others and then make the same choice that the others have made, independently of their own private information signals. Investors feel reassured by the behavior of the group; collective emotions come into play to feed the cascade : they can be positive emotions during the rise of the bubble, when a given good or security becomes a coveted luxury item and a status symbol, a tulip bulb during the tulips mania in February 1637 or a technology stock during the dot come bubble, but they can also be negative emotions when market fear spread and market temperature (volatility) goes up to 80 (historical 30 days or implied volatility, October 2009), market are dislocating, the bubble is bursting - emotions are fighting against rational information...

These competing forces are coexisting and the contribution of one force vs the other can be observed-but-not-predicted through prices co-movements and spectral analysis : first seismic waves cannot be predicted - yet it does not mean that anti-seismic, or robust, investment strategies cannot be designed. Like an anti-seismic building, some active mechanisms can be designed so that some predictability at the portfolio level can be obtained as elegantly presented by Alexandre d'Aspremont, assistant professor at Princeton University (Operations Research and Financial Engineering) in [3] using eigenvalues (wave energy levels!) and eigenvectors (wave functions!) of a well chosen "Oscillating" operator combining time (auto-correlation) and space (assets co-movements) correlations between various assets.

[1] Robert J. Shiller. "How a Bubble Stayed Under the Radar?" - New York Times, March 2, 2008.

[2] Pollan, Michael (2002), The Botany of Desire, New York: Random House, ISBN 0-375-76039-3

[3] A. d’Aspremont "Identifying Small Mean Reverting Portfolios." - Princeton University - Preprint, February 2008.