Financial Models for trading and investments – Part 2

This is part II of the article: Financial Models for trading and investments – Part 1. Please read the article from the first part before proceeding with this one.

However, the simple and faulty assumption that is made is about the future repeat of the historical occurrences. There is NO GUARANTEE that whatever has occurred in the past, happens again in the future. Still, the individuals justify their quantitative work by saying that “Every model needs assumption, so we have to make some”. However, the truth is that in the practical world, there is nothing that works according to our assumptions. We can make assumptions, follow any models, they may be profitable but who knows when it might fail.

I have myself seen practical models in place in the finance industry which are built upon lots of faulty assumptions. One such model I spotted was being followed for a 10 year long investment period. I changed the period from 10 years to 11 years. The model showed a completely different result. Positive returns turned out to be negative and the risk increased severely.

Take the very simple example. We all love sports like football and cricket. When it comes to the Worlds Cups of these 2 games, we see that there is always a lot of controversy about the format of the initial level matches, the intermediate rounds, as well as the higher level elimination rounds. The point system itself is questionable.

The last cricket world cup was blamed of being too lengthy. Also, when India and Pakistan were out in the very first round, questions were raised about the format of elimination. Same was the case with the previous world cup, where some teams got indirect benefit in the mid-level rounds of the world cup.

Then another big one: The Duckworth Lewis Method. Since a long time, people have been complaining about the DL Method. However, no one is able to suggest a better model to follow. It is controversial, and not perfect. And I am sure that the situation will remain as it is for a long time, may be till the time I live :- )
Some other model may replace DL Method, but some new problem will sprung up.

ICC is working hard to find a better format of world cup – they are yet to discover one and they will stay there itself. Same goes with the football games.

In essence, following a model is nothing but fooling ourselves. When experienced finance professionals cannot make up any fool-proof models, how do the strategies or models that we individuals, from non-finance background, can work effectively.

Things work randomly. Try to be practical, and don’t base the judgements on assumptions. Only play around with the money that is really extra. And yes, first identify whether you really have extra money :- )


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You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.