This note is one of a series about the books that have informed and inspired my life and work. Click here for the previous book, You Can Be A Stock Market Genius.
One in 20 million… one in 50 billion… one in 500 billion… Statistically, capital markets seem to experience events that are outliers far from normal expectations on a surprisingly frequent basis. This is especially surprising if one relies on normal distribution curves at the heart of most conventional prediction models. However, we don't live in a normal world. Instead we live in a wild world or, as Prof. Mandelbrot, author of The Misbehavior of Markets: A Fractal View of Financial Turbulence, would say, a "rough" world.
What was applicable? Prof. Mandelbrot does not offer anything like a complete replacement for modern portfolio theory (MPT), but he throws the whole edifice into question. A lot of conventional research uses bell curves to describe how markets work because they are easy to calculate, not because they describe the real world. This book pokes many holes in MPT, illustrating how price changes over a series are not independent of one another. Here is how Mandelbrot describes market behavior:
"Markets are risky"
Extreme moves are the norm. They are not some freak occurrence that occasionally victimizes investors. What does that mean for practitioners? Well, it means that we cannot simply look to prices - especially recent prices - to linearly project a reasonable range for where securities will trade in the future. It means that we can benefit in the future from dislocations by keeping excess flexibility in reserve. Flexibility can be conserved in the form of low leverage, long lockups, patient investors, broad mandates, and a low run rate of professional pressure. It is important that we stay flexible because we will have opportunities to exploit inflexible counterparties when the next one in a billion opportunity arrives next year or next month. More importantly, we need to stay more flexible than our average competitor.
"Trouble runs in streaks"
In markets, there are often clusters of turbulent periods. Market participants are not independent variables - we are dependent in that we profoundly and directly impact each other's behavior and this dependency increases when there is greater turbulence. Most money is made and lost in the markets during a small subset of the trading days.
"Markets have a personality"
Markets should be driven by exogenous factors such as war and peace, economic cycles, and the rise and fall of corporations. But in practice, the interaction of market participants, such as investors, brokerages, banks, and exchanges, creates its own impact on the market. Like in a game of poker, this means that a lot of our analysis comes down to analyzing our counterparties. Frequently, the identity and behavior of those market participants is as impactful as the underlying economics of the given security that we are analyzing.
Markets appear to have more patterns than they really do. A dangerous aspect of investing is that such patterns appear to be predictable and exploitable. But a lot of this is random and dangerous to anyone seeking to profit from precise predictions with price as the sole input.
"Market time is relative"
Time in capital markets is not the same as time measured by clocks; instead, in capital markets, time expands and contracts in times of high and low volatility. So, the author is never surprised by events that are not described by normal models.
In describing how real markets work in a manner that is more predictive and more consistent with most natural phenomenon, Mandelbrot has the mind of a genius. He is one in a billion, or may be one in 100 billion.
Mathematical superstar and inventor of fractal geometry, Benoit Mandelbrot, has spent the past forty years studying the underlying mathematics of space and natural patterns. What many of his followers don't realize is that he has also been watching patterns of market change. In The (Mis)Behavior of Markets, Mandelbrot joins with science journalist and former Wall Street Journal editor Richard L. Hudson to reveal what a fractal view of the world of finance looks like. The result is a revolutionary reevaluation of the standard tools and models of modern financial theory…
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.