Book Review: The (Mis)Behaviour Of Markets: A Fractal View Of Risk, Ruin And Reward

by: Bram de Haas


A book by mathematician Benoit Mandelbrot that explains his findings in a language non-mathematicians can understand.

Mandelbrot gives an overview of the history of financial theory and puts his ideas in that context.

Or rather explains how much of it came to be and why it's flawed.

You can ultimately dismiss his ideas but it is a mistake not to take note of their existence.

On the night of February 1, 1953, a very bad storm lashed the Dutch coast. It broke the famous sea dikes, the country's ancient and proud bulwark against disaster. More than 1,800 died. Dutch hydrologists found the flooding had pushed the benchmark water-level indicators, in Amsterdam, to 3.85 meters over the average level. Seemingly impossible. The dikes had been thought to be safe enough from such a calamity; the conventional odds of so high a flood were thought to have been less than one in ten thousand. And yet, further research showed, an even greater inundation of four meters had been recorded only a few centuries earlier, in 1570. Naturally, the pragmatic Dutch did not waste time arguing about the math. They cleaned up the damage and rebuilt the dikes higher and stronger.

Mandelbrot tells the above story in the (Mis)behaviour of Markets and coincidentally my grandfather happened to live in an adjacent province of Zeeland, where this tragedy took place. In the aftermath he went there to help.

In addition to the 1800 people who lost their lives an additional 100.000 lost their homes and often everything else they had. A great tragedy that had an enormous impact on a small country and as of yet, it continues to be part of the cultural memory. When I look at the photographs of the era what strikes me is how the landscape is littered with the black and white Holsteins.

Source: ISGeschiedenis

Mandelbrot uses this example because the mistakes made are analogous to those currently being made in much of the financial world:

Such pragmatism is needed in financial theory. It is the Hippocratic Oath to "do no harm." In finance, I believe the conventional models and their more recent "fixes" violate that oath. They are not merely wrong; they are dangerously wrong. They are like a shipbuilder who assumes that gales are rare and hurricanes myth; so he builds his vessel for speed, capacity, and comfort-giving little thought to stability and strength. To launch such a ship across the ocean in typhoon season is to do serious harm. Like the weather, markets are turbulent. We must learn to recognize that, and better cope.

Conventional models would be the Efficient Market Hypothesis, the Capital Asset Pricing Model, Modern Portfolio Theory and the Black-Scholes model. In Mandelbrot's eyes these models are not just useless but an active threat as they lull us into sleep thinking we've got our bases covered.

Like the Dutch of 1953 went to bed thinking the dykes would keep them safe from the incoming North West storm as they had many times before; we go to bed convinced our portfolio is well diversified and will be resilient even through downturns.

Nassim Taleb is worried about the same things and has described the use of these models as analogous to explorers going into unknown territory who chose to rely on "a random map" insisting it is better than having no map at all.

Mandelbrot actually offers a map or model that works better to describe how markets work called the Multifractal Model of Asset Returns.

If you are like me and pretty much incapable of any math comprehension don't worry, you'll still get a lot out of this book.

Mandelbrot goes out of his way to present his findings in a way that's useful and practical by trying to capture them in rules. The book isn't that useful in the sense it will help you pick stock A, B or C but it does help you understand why leverage is extremely dangerous and why it's possible the market drops 25% within a day or 50% in short time span. It offers reassurance you aren't crazy if you don't optimize your portfolio for maximal return.

Ultimately, Mandelbrot describes his model as follows:

the multifractal model successfully predicts what the data show: that at short time-frames prices vary wildly, and at longer time-frames they start to settle down

Which is something Benjamin Graham knew all along:

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

― Benjamin Graham

The lesson: We have to build enormous dykes or simply put survival first.

You can view the book as the theoretical explanation of what certain value investors have observed and acted upon since Benjamin Graham laid the foundation of the investment style. The advice of lots of famous value investors fits in perfectly with Mandelbrot's findings, with insights that constitute practical ways to implement his advice:

"So one way to create an attractive risk/reward situation is to limit downside risk severely by investing in situations that have a large margin of safety. The upside, while still difficult to quantify, will usually take care of itself. In other words, look down, not up, when making your initial investment decision. If you don't lose money, most of the remaining alternatives are good ones."

― Joel Greenblatt, You Can Be a Stock Market Genius

I learned that if I can simply survive in the market, just like surviving in the war, and not lose money, eventually I will make something.

― Walter Schloss

People should be highly skeptical of anyone's, including their own, ability to predict the future, and instead pursue strategies that can survive whatever may occur.

― Seth Klarman

Some value investors, I suspect, actually read Mandelbrot's work and seamlessly integrated it into their thinking:

When people talk about sigmas in terms of disaster probabilities in markets, they're crazy. They think probabilities in markets are Gaussian distributions, because it's easy to compute and teach, but if you think Gaussian distributions apply to markets, then you must believe in the tooth fairy. It reminds me of when I asked a doctor at a medical school why he was still teaching an outdated procedure and he replied, 'It's easier to teach.'

― Charlie Munger (May 2007)

If the The (Mis)Behaviour of Markets: A Fractal View of Risk, Ruin and Reward can help you to lower the odds of getting wiped out by underestimating the probability of ruin, it will have been a purchase of terrific value.

Chances are it will set off a chain reaction of beneficial reading and you go on a tour of reading terrific stuff like Against the Gods, The Incerto, Alchemy of Finance and the Dao of Capital. After all good reading is no random walk either.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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