The (Mis)Behavior of Markets

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The (mis)behavior of markets

by Benoit Mandelbrot and Richard L. Hudson

Basic Books © 2004, 328 pages, $27.50 (ISBN 0-465-04355-0).

A Fractal View of Risk, Ruin and Reward

The work of mathematical genius Benoit Mandelbrot has been turning heads since the early 1960s. As an award-winning scientist, he has always broken from the pack of others to originate groundbreaking ideas that simplify complex problems and forces, such as the forces that create complexity in financial analysis. One of these ideas is fractal geometry (a scientific discovery which makes computer animation possible).

A fractal is a geometric shape that can be broken into smaller parts, each a small-scale echo of the whole, such as the branches of a tree or the bifurcations of a river. Fractal geometry goes beyond the smooth lines and planes of circles and squares and applies wherever roughness is present. Studying roughness, Mandelbrot found fractal order where others had seen only disorder, and changed our view of nature as well as the irregular charts of a stock index or exchange rate. In The (Mis)Behavior of Markets, Mandelbrot and Wall Street Journal editor Richard L. Hudson explore marketplace risk and how Mandelbrot’s fractal theories can be used to predict marketplace outcomes and make the market more secure.

According to the authors, fractal finance is a tool that can be used to reduce the way a specific price varies to a small number of mathematical theories and models. With these powerful tools, an analyst can model how an asset behaves, process various possible scenarios with computer models, and evaluate the risk of an investment with more accuracy. Prices of trade goods and exchange rates, for example, might not be able to be predicted with complete accuracy, but the authors write that they can be measured and characterized, and their volatility can be forecast.

Shaky Business

Throughout The (Mis)Behavior of Markets, the authors explain that much of “what passes for orthodoxy in economics and finance proves, on closer examination, to be shaky business.” As someone who has always disrespected “received wisdom,” Mandelbrot writes that his ideas about economics come from observation, and not abstract theory. As a practical and objective observer of the patterns of financial markets, he has collected 10 “obvious” facts. He calls these his “Ten Heresies of Finance.” They include:

  1. Markets Are Turbulent. After studying the patterns found in wind tunnels and ocean currents, Mandelbrot applied his “multifractal” math to the analysis of financial markets. He writes, “The tell-tale traces of turbulence are plainly there, in the price charts. It has the turbulent parts that scale up to echo the whole.” The normal expectations of the bell curve do not capture its changes, and only the metaphor of turbulence can be used to describe it.
  2. Markets Are Very, Very Risky — More Risky Than the Standard Theories Imagine. Turbulence is dangerous because it can swing wildly and suddenly. Not only is it hard to predict, but it is harder to protect against, and hardest of all to engineer and profit from.
  3. Market “Timing” Matters Greatly. Big Gains and Losses Concentrate Into Small Packages of Time. Since news events like corporate earnings releases and inflation reports help drive prices, big news can cause big market action, and that action concentrates in small slices of time. Particulars matter more than averages, the authors point out, so getting the timing right can produce giant windfalls, such as the two weeks in 1992 when George Soros made $2 billion by betting against the British pound.
  4. Prices Often Leap, Not Glide. That Adds to the Risk. The conceptual difference between economics and classic physics is the capacity for jumps, or discontinuity. In financial markets, news can compel many investors to act all at once, now and instantaneously.

Why We Like This Book

The (Mis)Behavior of Markets re-evaluates the standard tools of financial theory and injects them with the insights of a man who uses simple explanations to dissolve the false assumptions that have caused many investors to underestimate the risks involved in the market. By pointing out the flaws in previous thinking, and using scientific research and ideas to ground his theories, Mandelbrot once again changes the way we think. ~

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