Book Review: 'Why Stock Markets Crash'

by: Jeff Pierce

Who doesn’t love a good stock market crash? Outside of short term traders, it’s an opportunity to reload your portfolio if you’re a long term investor and a chance to dip your toes into the world of Wall Street if you're a newbie. The lore associated with stock market crashes fascinate nearly all involved in the game of investing, just is the case that the fear of a crash paralyzes most traders, in extreme cases keeping them up at night and fearful to pull the trigger on a trade.

While it’s easy to get caught up in the drama surrounding a crashing market, Didier Sornette's Why Stock Markets Crash attempts to pinpoint the reasons that actually cause the markets to fall through analysis of previous crashes, simulated models, and high-tech math equations. While it’s easy to fault the book for being too technical, I feel that the author does a great job at explaining the science behind that math and offers solid insights that any trader will appreciate.

Sornette starts the book where you would expect any study of stock market crashes to start, with many of the most famous stock market crashes history. I found this interesting as there is always some nugget of information that one did not know previously when studying history, such as how the South Sea Bubble was very much like the Ponzi schemes of late .

Given that the book was published in 2003, it’s a shame that it wasn’t published recently, as it would have been interesting to see the author’s take on the economic collapse of ’08 and the subsequent Flash Crash that occurred on May 6, 2010. Although when you look back at a daily chart of the Dow Jones, the Flash Crash barely registers a blip on the recent economic recovery. If there’s one thing that all crashes have in common, it’s that they “are caused by the slow build-up of long-range correlations leading to a global cooperative behavior of the market."

The author pits the random walk theory verses the efficient market theory, and I couldn’t discern a clear winner as I made my way through the many charts and complicated formulas that only a geophysicist such as Sornette would truly understand and appreciate. I feel you should replace the word "random" with "irrational," as “that rationality tends to be hampered by cognitive biases, emotional quirks, and social influences.” Your social network on which you discuss the markets with friends, family, or fellow Twitterers, become your tribe and has a large influence over your trading and investment decisions.

One thing I did discover about myself, as I’m a short-term oriented trader, is that I’m one of the “noise” traders that are needed to provide the liquidity that is essential for the capital markets to work efficiently. Noise traders, as defined by Sornette, are “speculators, or traders basing their strategies on technical indicators."

Simplicity is an essential concept when trying to create a model for an early warning crash-detection signal. Crashes by their very nature are outliers, i.e. a phenomena that lies outside of everyday experience, and to try and develop a system that capitalizes on this, it must be very simple. That’s what make them so difficult to predict, since they only happen every couple of decades. It’s the stock market bubbles that many think lead to these outliers, but the author dismisses this myth in favor of the belief most bubbles are self-correcting.

Given that trading is so emotional, this book focuses on a lot of psychological issues such as the disposition effect, which I feel most traders can relate to. It’s passages like the one I've paraphrased below, defining this effect, that make this book so valuable:

“People value gains and losses relative to a reference point and have a tendency to seek risk when faced with possible losses but to avoid risk when a certain gain is possible," while most traders are “overconfident about their own relative abilities and unreasonably optimistic about their futures.” Those are a few important concepts that all traders should keep in mind when they are so sure that a trade is going to go in their favor that they forget to add a stop.

While it’s difficult to pinpoint what type of trader would enjoy this book the most, I think there’s something for everyone, whether you're a quaint, technical trader or a fundamentalist. At the time of this printing, Sornette called the U.S. the biggest bubble of them all, so I would be very interested to hear what he thinks about the future implications of QE1 and the sequel QE2. Yes, there are areas of the book that went completely over my head, but for every formula that had too many x’s and y’s, there was an important concept that had me reaching for my pencil to make a note so I could revisit that concept or idea in the future.

I feel that I’m smarter after finishing this book; I thoroughly enjoyed the lengthy journey, and would recommend this to any stock market enthusiast.