Aimen Rizouk: Chess and the Stock Market

by ChessBase
11/14/2011 – Now we don't want to drive the world's top GMs from the chess world to the stock exchange, but have you ever considered whether the two areas have anything in common? Whether the "Prudent Man Rule" of economics can learn from the romantic era of chess, or behavioral finance from Bobby Fischer? Here's a grandmaster who has studied the subject and presents us his conclusions.

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Chess and the Stock Market

By GM Aimen Rizouk


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.


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

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