Thursday, May 30, 2019

The Misbehavior of Markets

The Random Walk Theory of prices does a half-decent job describing the behaviour of markets in general. But if you want to get specific, it does have a couple of key problems. First, it assumes price changes are independent of each other, which statistical studies have shown to be false. And second, the number of events taking place in the tails is underestimated; the bell curve assumed is far too simplistic for modeling actual market returns.

In The Misbehavior of Markets: A Fractal View of Financial Turbulence, author Benoit Mandelbrot offers a better way to model markets, using a math concept called a fractal.

I won't pretend to understand the math behind modeling fractals, but the concept is basic enough: An object's structure appears or is the same even as you scale up/down. So for example, a tree has branches, which in turn have their own branches, which have their own tiny branches etc.

Mandelbrot argues that a market scaled by time acts like a fractal. If you take away an axis' labels, a trader can't tell the difference between a short-term chart and a long-term chart. A daily price chart looks much like a monthly chart which looks like an annual chart. This powerful feature allows markets to be modeled better than tools which rely on a bell curve assumption.

The book was interesting, but add it to the substantial pile of books that could have been just as effective as a much shorter article.

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