The (mis)behaviour of Markets

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GTY_bernie_madoff_cf_160125_12x5_1600 (1)You can’t help but feel amazed at the intellectual bandwidth the late legendary mathematician Benoit Mandelbrot possessed. For the starters, Mandelbrot gave us the chaos theory, the fractal theory and several other towering milestones in physics, finance, etc. ‘The Misbehaviour of Markets’ is not his seminal work, but it’s heads and shoulders above the drivel that often adorns the finance bookshelves. The book primarily deals with: a) Standard financial models and their deteriorating contribution to the understanding of risk, and b) Use of fractal theory as an alternative to standard models.

Mandelbrot’s skepticism of traditional economic models stems from the serial cataclysmic failures that these half-baked models have wrought upon the world over the years. According to him, the standard finance models such as CAPM, modern portfolio theory, Black-Scholes options pricing model, etc., all disregard the true nature of financial markets.

“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

Build around the mild-natured bell curve, these models barely prepare the investors for the wild, disproportionate price swings that often dart the stock markets. Technically, if the markets actually operated in accordance with the bell curve, there would be no market crashes and no meltdowns. The biggest ever single-day point crash of September 29, 2008 – the odds for which otherwise were estimated to be about 1 in a billion – should never have happened in a Gaussian-curve perfect world.

Mandelbrot exposes the blindfolded obeisance to the bell-curve-inspired models by bankers, economists and investors alike. Despite the evidence emerging into the shortsightedness of the Gaussian curve, the financial illuminati continue to cling on to these models. Financial world’s idée fixe with these corrupt models frustrates Mandelbrot and he vehemently questions this reluctance to change. He denounces Eugene Fama’s (his own Ph.D. student) grand edifice Efficient Market Hypothesis and 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.” While these theories continue to live on after having entrenched themselves firmly over the last four decades, Mandelbrot suggests an alternative of his own: the fractal theory.

On his part, Mandelbrot hangs the blame for our limited perspective on the inadequate and sometimes, partisan research in the field of financial market analysis. As most research projects tend to be sponsored, the results only scratch the surface of the problems that lie beneath. Mandelbrot synthesises the lack of fundamental research into a pithy assertion,” 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.”

We have been mismeasuring risk“, says Mandelbrot. Over the years, the elites of the financial world have relied heavily on ‘standard deviation’ and ‘beta’ – the two orthodox yardsticks of finance to calculate volatility and risk. While true in their own right, these measures are the offsprings of the Bell curve, built upon assumptions that a) prices are largely independent and b) markets are generally well-behaved. Mandelbrot counter-theorizes that a) stock prices have a memory (Joseph effect), i.e. prices of today do affect the prices of tomorrow and b) markets are inherently turbulent (Noah effect).
One of the key orthodoxies of modern finance decimated by Mandelbrot is that of price independence. The assumption underlying several finance theories is that stock prices jump from one level to another in an independent manner, i.e., yesterday’s stock price isn’t supposed to have any bearing on today’s price. On balance, the theory of price independence closely mimics the coin-tossing whereby each subsequent event is independent of the previous one. Chances of getting a head or a tail are 50-50 and have nothing to do with previous data points. On the contrary, Mandelbrot asserts that stock prices, currency rates and commodity futures – all are entwined to a significant degree. Consequently, prices have a certain ‘memory’ and are dependent. For instance, Tata’s acquisition of Jaguar and Land Rover shall reflect in Tata Motors’ price over a long time. IBM’s midwifery of both Intel and Microsoft in the ’80s manifested in its stock price for a long time.
As a reader, I admire Mandelbrot’s application of metaphors to simplify the convoluted yet interesting financial concepts. For example, he intermingles the mythical accounts of Noah and Joseph from the Old testament with two forms of wild variability – ‘abrupt change or turbulence’ and ‘almost-trends or dependence’ – and coins the respective metaphors: the ‘Noah Effect’ and the ‘Joseph Effect‘.
Noah Effect characterizes the inherent turbulent nature of stock markets, the destructive yet transient events just 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. It appeared to many as the onset of another great depression, but instead the markets bounced back sooner than expected and Dow Jones ended the year higher than it had started. Joseph Effect – after Joseph’s interpretation of Pharaoh’s dream that seven years of famine would follow seven years of prosperity – signifies almost-trends or dependence, i.e., 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 more 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. Joseph Effect is quantified by Hurst component (H) on a scale of 0 to 1. If H exceeds 0.5, the trend is a persistent one, that is, it’s in line with Joseph Effect.

In a rather contradictory assertion, Mandelbrot rules out the theory of chance governing the stock prices. To him, it’s all cause-and-effect – something that is easy to work out afterwards, but difficult to forecast beforehand. However, our inability to fathom out which factors influence prices in the ‘real time’ necessitates the reliance on probability to make further forecasts. 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, by his own account, 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 last chapter of the book, he encapsulates all his contrarian wisdom into ten heresies of finance – a must read for any investor.
In conclusion, ‘The misbehavior of markets’ shall radically change your perspective on the standard tools and models of finance. The book’s narrative is as mentally stimulating as it’s intellectually satisfying. Mandelbrot deliberately avoids any tricky financial mumbo-jumbo so as to widen the readership of the book. Many ideas, especially those related with the bell curve, may not sound altogether new to the reader, but that’s only because others have worn out Mandelbrot’s ideas before you got to this book. The sole drawback (for some readers) could be the technical part where Mandelbrot gets into the nuts and bolts of fractal theory. Unless you are well-versed with charts and graphs, the exercise to comprehend the fractals could prove cumbersome. Nonetheless, the wonkish portion constitutes 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.