Chess and the Stock Market
By GM Aimen Rizouk
Abstract
Chess is fascinating, you can think of it as a game, an art, a science, a
sport or a combination of all of these. For those who sought its usefulness
outside the sixty four squares board, they found military strategy, indeed,
throughout history chess has been mostly depicted as a wargame. But who knows?
Chess may find many other applications in life, perhaps economics and finance.
This article compares and contrasts the fields of chess and investment.
1. Introduction
In an article published in the Guardian newspaper in 2004 titled: Chess
what is it good for? we read in the byline: "War, say researchers in
Sweden and Australia. They are using the game to improve understanding of real
battles, where you can't always see what your opponent is up to." This
has materialized the concept of chess seen by Emanuel Lasker, the world chess
champion between 1894-1921, who wrote the following in his book Common Sense
in Chess back in 1896:
"Chess has been represented, or shall I say misrepresented, as a game
– that is a thing which could not well served a serious purpose, solely
created for the enjoyment of an empty hour. If it were a game only, chess
would never have survived the serious trials to which it has, during the long
time of its existence, been often subjected. By some ardent enthusiasts chess
has been elevated into a science or an art. It is neither, but its principle
characteristic seems to be what human nature mostly delights in – a
fight. Not a fight – indeed such as would tickle the nerves of coarser
natures – where blood flows and the blows delivered leave their visible
traces on the bodies of the combatants, but a fight in which the artistic,
the purely intellectual element holds undivided sway."
Aron Nimzowitsch, one of the best players in the world on the early 1930s
and one of the most important writers in chess history, highlighted a strategic
concept in chess that maybe valid in the battle field too. He mentioned: "The
attacker relies mainly on his territorial superiority – on the superior
state of his lines of communication. The game is lost because at some point,
it proves impossible for the defender to keep pace with his opponent in his
rapid regrouping of his forces."
Now let's put forward the following question: Chess – is it good for
the stock market?
2. Prudent Man Rule and Romantic Chess
In 1830 the "Prudent Man Rule" arose from a celebrated Massachusetts
court decision, Harvard College versus Amory. Under the Prudent Man Rule, speculative
or risky investments must be avoided. Certain types of investments were imprudent
per se and thus prohibited as fiduciary investments. Moreover, each investment
in a trust portfolio, rather than the portfolio as a whole, had to satisfy the
tests of prudence.
Over time improvements were introduced to the Prudent Man Rule, by taking
into account new developments in the field of finance, such as Modern Portfolio
theory (MPT) advanced in 1952 by later Nobel laureate Harry Markovitz. The fundamental
concept behind MPT is that the assets in an investment portfolio should not
be selected individually, each on their own merits. Rather, it is important
to consider how each asset changes in price relative to how every other asset
in the portfolio changes in price. The theory provided an optimal way of diversification,
and laid the ground for a scientific way of managing wealth based on the tradeoff
between risk and return.
This revolutionary change could be compared to the birth of "scientific
chess" at the end of the nineteenth century ending a long era of "romantic"
chess. Romantic chess is the style of chess distinguished by open, sharp and
spectacular play, a typical game would involve an aggressive attack targeting
the king, often carried through bold material sacrifices, which were rarely
declined. This style reached its peak on the mid of the 19th century and was
personified by a group of leading players such as Paul Morphy, Henry Blackburne
and Adolf Anderssen – the latter produced brilliancies over the board,
like the Immortal Game and the Evergreen Game, masterpieces that inspired generations
of players. Contemporary chess master Pal Benko, describing a game played during
the romantic era, remarked: "A typical chess game of a hundred years ago
was like a medieval jousting contest: brutal and direct. Both sides, intent
on straightforward attack against the enemy king, generally galloped toward
each other with lances bent. The possible endgames that could result from a
given strategy were hardly considered. All that mattered was checkmate."
Manly pride played an important role in this philosophy of the game. When a
player offered a speculative sacrifice on the chessboard, he was throwing down
the gauntlet, challenging his opponent to a duel; it could not honorably be
declined. When a player attacked, he attacked the king; he would no sooner bend
down to pick up a loose pawn than he would joust with a child".
Toward the end of the nineteenth century, many leading players began to see
the tradition of manly honor in chess as foolish and self-destructive. Prudence
and pragmatism began to supplant bravado, added Benko.
3. Modern Chess (Wilhelm Steinitz) and Efficient Market Hypothesis (Eugene
Fama)
Wilhelm Steinitz was born in Prague in May 17, 1836, and was the first undisputed
world chess champion, from 1886 to 1894. He was the first to realize that chess
obeys some theoretical principles that needed to be discovered. He developed
the positional style of play which was to become the basis of modern chess,
which has effectively ended the romantic style at the highest level.
Eugene Fama, an American economist born in 1939, is widely recognized for
his outstanding contributions to modern finance. He proposed the efficient market
hypothesis (EMH) in his PHD thesis in 1970. EMH is an investment theory that
asserts the impossibility of consistently outperforming the market on a risk-adjusted
basis, given the information available at the time the investment is made, because
stock market efficiency causes existing share prices to always incorporate and
reflect all relevant information.
Opponents of EMH not only pointed to evidence that suggests the weakness of
the theory, especially the strong form of EMH, which suggests that markets are
efficient enough to prevent making above average profits from insider trading.
But also to the fact that the theory cannot explain stock market crashes.
4. The Rise of Behaviorists in Finance and Psychology in Chess
Behavioral finance is the study of how psychology affects financial decision
making and financial markets. Unlike traditional finance which assumes that
people behave with extreme rationality, behavioral finance relaxes the traditional
assumptions of financial economics by incorporating observable, systematic,
and very human departures from rationality into standard models of financial
markets. The proponents of behavioral finance, argue that a few psychological
phenomena pervade the entire landscape of finance. These phenomena are centered
around three themes.
-
Heuristics: The use of rules of thumb to process data,
for example: "Past performance is the best predictor of future performance,
so invest in a mutual fund having the best five-year record." In contrast,
traditional finance assumes that when processing data, practitioners use
statistical tools appropriately and correctly.
-
Frame dependence: The description or frame of a decision
problem, behavioral finance postulates that in addition to objective considerations,
practitioners' perceptions of risk and return are highly influenced by how
decision problems are framed. In contrast, traditional finance assumes frame
independence, meaning that practitioners view all decisions through the
transparent, objective lens of risk and return.
-
Inefficient markets: Behavioral finance assumes that heuristic
driven bias and framing effects cause market prices to deviate from fundamental
values. In contrast, traditional finance assumes that markets are efficient.
Efficiency means that the price of each security coincides with fundamental
value, even if some practitioners suffer from heuristic-driven bias or frame
dependence.
Lasker was the first to realize that psychology plays a role in a chess game.
He stated:
"There can be but one objective in a fight, winning. What does it matter,
in the heat of a battle, whether or not a plan is theoretically sound? Simply
put, if it works, it's good; if it doesn't, it isn't. Chess is played by human
beings, Lasker emphasized, and to disregard their human frailties-that is,
to play the board-is to close one's eyes to a world of winning opportunities.
To play with common sense means not only to choose plans according to the
characteristics of the position-that goes without saying-but also with due
regard for the characteristics of the opponent. "Chess is a fight in
which all possible factors must be made use of," he asserted; "a
knowledge of the opponent's good and bad qualities is of the greatest importance."
Lasker's teachings were followed by generations of great players and world
champions such as Alekhine and Botvinnik. They themselves developed and employed
the concept of psychology in chess. Nowadays, psychology is systematically employed
in chess at all levels of competition – most chess players recognize its
importance and strive to make use of it as much as they can both at the chess
board or while preparing against their opponents.
5. Computer Chess and Algorithmic Trading
Since the introduction of the first chess programs that could play chess autonomously,
without human intervention, there have been a special interest in the human
intelligence versus artificial intelligence contest. Early programs which were
developed in the 1950s were weak, and only in the 1980s computers started to
compete with chess grandmasters.
Today it is obvious that the machine surpassed man in chess. Back in 1997
Deep Blue beat the then World Champion Garry Kasparov 3.5-2.5 in a six-game
match, and the last major confrontation was also won convincingly with a score
of 4-2 in the six-game match between world champion Vladimir Kramnik and the
Deep Fritz chess program in 2006. This trend is not expected to reverse –
more computation power as well as better algorithms will widen the gap even
further in the future, the battle man versus machine in chess is over.
Former world champion and legendary chess master Garry Kasparov dedicated
a chapter in his book, How Life
Imitates Chess, to Man vs. Machine, and in a section titled: " If you
can't beat 'em, join 'em", he explained how "Advanced Chess"
emerged. This time it was not man vs. machine but man vs. man both assisted
by a machine. Advanced Chess did not prove that popular however.
Algorithmic trading (AT) in financial markets refers to any automated systems
deployed for the purpose of entering trading orders, or even implementing a
technical trading system on a completely automated basis. Once the system is
developed and deployed, the intervention of the human hand is not required to
operate these systems – although, of course, it is desirable to closely
monitor the operation and performance of such systems to establish prudent credit
controls.
A subset of algorithmic trading is high-frequency trading (HFT), a trading
platform that uses powerful computers and complex algorithms to transact a large
number of orders at very fast speeds based on information that is received electronically.
Algorithmic trading is widely used by pension funds, mutual funds, and other
institutional investors, and has become increasingly significant components
of the order stream in many capital and commodity markets. In the process, many
opinions and concerns have surfaced regarding the impact of AT and HFT practices
on market dynamics. Some analysts argue that AT serves to enhance liquidity,
which in turn mitigates untoward price volatility. Others have suggested that
AT practices may exacerbate price volatility and lead to reduced liquidity,
particularly in times of market stress.
Controversies: During the world chess championship match held in Russia in
2006, the team of the Bulgarian contender Vaselin Topalov made a complaint against
their Russian rival Vladimir Kramnik, implying that he might be receiving computer
assistance. This infamous scandal was labeled "Toiletgate". Similar
incidents happened at the Moscow Chess Open and the Chess Olympiad in 2010,
and there is a growing concern among professional chess players that illegal
use of computer might hinder fair competition between humans.
Algorithmic trading and high-frequency trading were implicated in the May
6, 2010 Flash Crash, when the stock market lost about nine percent of its value,
the Dow Jones Industrial Average fell by nearly 1000 points before rebounding
swiftly and making up those losses within minutes. This unprecedented event
highlights the downside of these automated systems, It took regulators several
months to reconstruct what happened in a span of minutes, indeed the Securities
and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC)
published a joint report nearly 5 months after the event, a report that did
not convince all market participants.
6. Conclusion
By observing in chronological order the events that unfold in both chess and
the investment world during the last two centuries, and if history is a guide,
behavioral finance will prevail over EMH, in spite of Fama skepticism (Eugene
Fama believes that market anomalies are chance events). Bobby Fischer too considered
psychology irrelevant in chess, and is quoted as saying: "I don't believe
in psychology. I believe in good moves." If Bobby did not need to use psychology
in chess, it might be because he was a psychological phenomenon himself, his
endless demands and countless grievances at the world championship match in
Reykjavik in 1972 resulted in bitter disputes with the organizers as well as
his rival Boris Spassky. The latter was shaken and put out of balance by the
unintended psychological warfare, a byproduct of Bobby Fischer's character.
Disregarding psychology in chess or in finance is to close one's eyes to a
world of winning opportunities. Alain Greenspan, the former chairman of the
Federal Reserve, once stated that what's common between the current and the
next economic crisis is human nature.
References
- Benko, Pal, and Burt Hochberg, 1991. Winning with Chess Psychology. Mckay
Chess Library.
- Shefrin, Hersh, 2002. Beyond Greed and Fear. Oxford University Press.
- CFA Institute, 2011. Level II Ethical and Professional Standards, Quantitative
Methods, and Economics. Pearson Learning Solutions.
- Dvoretsky, Mark, 2002. Strategic Play School of Chess Excellence 3. Edition
Olms.
- Barber and Odean, 1999. Behavioural
finance
- CME Group, 2010. Algorithmic trading
and market dynamics
About
the author
Aimen Rizouk has been a chess grandmaster since 2007. His current rating is
2539, the highest FIDE rating in Algeria since 2001. He is the three times winners
of the Arab Junior Championship (1994, 1996, 1998), the winner of the national
individual Algerian Championship 1999, second in the African Individual Championship
1999, Gold medalist on the first board in the Arab games in Egypt 2007.
As for his studies in finance, Aimen is a Level II candidate in the CFA
program.
Copyright
Rizouk/ChessBase