Computers are everywhere. I have three on my desk. How many do you have in your home? What was the world like before computers? In the land of mathematics and finance, it was spread sheets and rudimentary calculators. We weren’t manipulating and analyzing huge amounts of data. We didn’t have things like operations research, linear and non-linear correlations or mathematical models. It wasn’t practical. And then IBM created computers.
The financial industry and our entire world were never the same. The ability to look at massive amounts of data allowed us to analyze and quantify life events by identifying their corresponding facts and figures.
How does this work? Think about a car. The harder you press the gar pedal, the faster the car goes. Hills, windstorms and other unknowns will have some effect, but the most important variable is how hard you press the gas pedal. Mathematically this looks like:
Speed of Car = Unknown Variable + Pressure on Gas Pedal
In the financial industry, these equations are highly regarded. Most money managers rely on them to formulate their investment portfolio. This type of portfolio is called the Modern Portfolio Theory. Between 80 and 90 percent of money managers use the Modern Portfolio Theory. (From last week you’ll remember there are “top up” and “bottom down” investors. Modern Portfolio Theory investors are “top up” investors. I am a “bottom down” guy.)
Did computers really change the game or are they simply another tool? I think they’re a tool. Computers cannot consistently predict unknown variables. People, not computers, recognize the intangibles of their business. These intangibles separate the companies that survived the Great Recession from those which didn’t.
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