Pragmatic Information Rates, Generalizations of the Kelly Criterion, and Financial Market Efficiency

TL;DR

This paper introduces a pragmatic information rate concept, extending Shannon's information theory to analyze decision-making, Kelly Criterion, and market efficiency, highlighting how information flow impacts financial market behavior and inefficiencies.

Contribution

It defines a pragmatic information rate and applies it to extend Kelly Criterion analysis and market efficiency, linking information flow to financial market dynamics.

Findings

Pragmatic information bounds bettor winnings in stochastic races.

Markets with GARCH(1,1) processes are shown to be inefficient.

Fast-changing fundamentals can cause market inefficiency, especially during bubbles.

Abstract

This paper is part of an ongoing investigation of "pragmatic information", defined in Weinberger (2002) as "the amount of information actually used in making a decision". Because a study of information rates led to the Noiseless and Noisy Coding Theorems, two of the most important results of Shannon's theory, we begin the paper by defining a pragmatic information rate, showing that all of the relevant limits make sense, and interpreting them as the improvement in compression obtained from using the correct distribution of transmitted symbols. The first of two applications of the theory extends the information theoretic analysis of the Kelly Criterion, and its generalization, the horse race, to a series of races where the stochastic process of winning horses, payoffs, and strategies depend on some stationary process, including, but not limited to the history of previous races. If the bettor is receiving messages (side information) about the probability distribution of winners, the doubling rate of the bettor's winnings is bounded by the pragmatic information of the messages. A second application is to the question of market efficiency. An efficient market is, by definition, a market in which the pragmatic information of the "tradable past" with respect to current prices is zero. Under this definition, markets whose returns are characterized by a GARCH(1,1) process cannot be efficient. Finally, a pragmatic informational analogue to Shannon's Noisy Coding Theorem suggests that a cause of market inefficiency is that the underlying fundamentals are changing so fast that the price discovery mechanism simply cannot keep up. This may happen most readily in the run-up to a financial bubble, where investors' willful ignorance degrade the information processing capabilities of the market.