The (mis)behaviour of Markets

The Misbehaviour of Markets

The late legendary mathematician Benoit Mandelbrot possessed an amazing intellectual bandwidth. He gave us the chaos theory, the fractal theory, and many other towering milestones. ‘The Misbehaviour of Markets’ is not his seminal work. But, it is heads and shoulders above the drivel that adorns the finance bookshelves.

Mandelbrot was skeptical of the traditional economic models such as CAPM, modern portfolio theory and Black-Scholes options pricing model. He held them responsible for unleashing serial cataclysmic failures upon the world. In his view, these models disregarded the true nature of financial markets.

Here’s Mandelbrot on the standard financial models:

“We have been mismeasuring risk. Too many financial models focus on ‘typical’ market behaviour based on ‘close enough’ approximations…Of what use is an average when the individual stocks diverge so widely and unpredictably from it?” – Benoit B. Mandelbrot

Built on the bell curve, these models do not prepare the investors for the wild price swings. If the markets actually operated under the bell curve, there would be no market crashes and no meltdowns ever. The biggest ever single-day point crash of September 29, 2008 – with 1 in a billion odds – should never have happened in a Gaussian-curve world.

Mandelbrot exposes the blindfolded obeisance to the bell-curve-inspired models. He denounces Eugene Fama’s (his own PhD student) grand edifice called Efficient Market Hypothesis. Along the way, he declares Louis Bachelier’s application of the Gaussian curve to the financial markets flawed.

He avers, “The Efficient Market Hypothesis is no more than that, a hypothesis. Many a grand theory has died under the onslaught of real data.”

The financial Illuminati continue to cling on to these models despite the strong contrary evidence. Financial world’s idée fixe with these corrupt models frustrates Mandelbrot.

It’s an acknowledged fact that most research projects are sponsored. So is the research in the field of finance. Mandelbrot hangs the blame for our limited perspective on the partisan research. More often than not, the outcomes only scratch the surface of the problems that lie beneath.

Here’s the author on the state of financial research:

“Financial Economics, as a discipline, is where chemistry was in the 16th century. A messy compendium of proven know-how, misty folk wisdom, unexamined assumptions and grandiose speculation.” – Benoit Mandelbrot

Over the years, the elites of the financial world have relied on ‘standard deviation’ and ‘beta’ to calculate volatility and risk. While true in their own right, these measures are the off-springs of the Bell curve. They operate under two assumptions. First, stock prices are largely independent and second, markets are generally well-behaved. Mandelbrot counter-theorizes. He says the prices of today affect the prices of tomorrow. Prices have a memory (Joseph Effect) and markets are inherently turbulent (Noah effect).

I love the way Mandelbrot deploys metaphors to simplify the convoluted financial concepts.

Joseph Effect signifies almost-trends or dependence. Mandelbrot named it after Joseph’s interpretation of Pharaoh’s dream that seven years of famine would follow seven years of prosperity. Any data point in a given time series is more likely to be a part of a trend than it is to be random. If a place has been suffering drought-like conditions, it’s quite likely that those conditions will persist. A huge jump in a stock today could continue to echo down the succeeding days’ trading, in the words of Mandelbrot.

Noah Effect characterizes the inherent turbulent nature of stock markets. The destructive yet transient events like the great flood of the old. The Black Monday of October 19, 1987, is a case in point when Dow Jones Index slipped by 22% in a single day. Many thought it was the onset of another great depression. Instead, the markets bounced back sooner than expected.

In a rather contradictory assertion, Mandelbrot rules out chance governing the stock prices. He declares it’s all cause-and-effect. Something that is easy to work out afterwards, but difficult to forecast beforehand. The world of finance, remarks Mandelbrot, is like a black box. You can only draw inferences as to whether the input A actually produces the output Z and vice-versa.

Mandelbrot never accepted the received wisdom hands down and neither should we. All his work in the field of economics and finance flows from observations he made as an investor and a researcher. In the final chapter of the book, he encapsulates his contrarian wisdom into ten heresies – a must read for any investor.

In conclusion, ‘The misbehavior of markets’ will change your perspective on the standard tools of finance. To his credit, Mandelbrot avoids any tricky financial mumbo-jumbo. Many ideas, especially those related to the bell curve, may not sound altogether new to the reader, but that’s only because others have worn out Mandelbrot’s ideas.

The sole drawback (for some readers) could be the technical part where Mandelbrot gets into the nuts and bolts of the fractal theory. Unless you are well-versed with charts and graphs, the exercise to comprehend the fractals could prove cumbersome. Nonetheless, the wonkish part makes up less than 20% of the text, and you can still glean loads of wisdom from the rest of the book. I jotted down several takeaways from the book. Hope you do, too.

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