Book: The (mis)behavior of markets

[Marshac]

Last week I spend two long days flying for work and managed to read two books; The Coming Generation Storm and The (mis)behavior of markets.

To be very blunt, the later book blew some serious chunks. My first reaction after reading 50 pages was "what an ego this guy (Mandelbrot) has!".... he invented fractal geometry and frequently likes to remind the reader about how smart he is.

The concept itself is interesting, and at the conclusion of the book, I would have to agree with his assertion- the models we have for measuring risk in the markets are inaccurate due to the underlying assumption that price fluctuations follow a normal distribution. Mandelbrot suggests that fractals can provide a better simulation of how markets behave than any other method we currently have, and could possibly be used to help predict market shifts.

My two cents- Werner Heisenberg made the observation that the act of measuring something changes the nature of that system- if fractals can be used to predict market trends, then they will alter the market and (probably) negate their usefulness as predictive tools. If nothing else, mass adoption of such a tool could possibly cause the market conditions they appear to be predicting (model predicts a drop, mass selling ensues, creating a large drop).

As models however, he did convince me that they are probably the best tools for portfolio survivability testing, and things of that nature.

Would I reccomend this book? No. Read the website instead.... note that in the "reviews" section, under the carefully worded "Praise for Mandelbrot and The (Mis)Behavior of Markets" heading, none of the quotes appear to review the book itself.

http://misbehaviorofmarkets.com/index.htm

 

[cute fuzzy bunny]

Marshac -

We're both up way too late. My excuse is a baby. You got one?

 

[Marshac]

It's not THAT late PST

I just got home from seeing million dollar baby, but don't have one myself... the only person I ever call baby is busy checking her email before we head off to bed.

 

[cute fuzzy bunny]

Alrighty then soldier.

Make us proud.


(I'm on PST also...when you're twice the age you are now, this IS late!)

 

[haha]

To be very blunt, the later book blew some serious chunks. My first reaction after reading 50 pages was "what an ego this guy (Mandelbrot) has!".... he invented fractal geometry and frequently likes to remind the reader about how smart he is.

Quite a few people who never invented anything like to remind us how smart they are.

At least Mandelbrot actually is! I read this book and had a completely different feeling from you. Quoting from the book:


"So what's wrong with the standard theories of finance?
Over the 20th century, economists have erected a mighty edifice of financial theory. From it, we have "Modern Portfolio Theory", by which stock portfolios can be built; the "Capital Asset Pricing Model", to price securities and value new factories or acquisitions; the "Black-Scholes" formula to price stock and other options contracts; and the "Efficient Market Hypothesis" - the economic theory behind the growth of stock-index funds and other forms of "passive" investment strategies. They all trace their origins back to a maverick French mathematician, Louis Bachelier, whose Paris doctoral thesis in 1900 pioneered the use of probability theory to model the way markets work. The problem is that all these modern models adopt Bachelier's original assumption that the familiar "bell curve" can describe how much prices vary up or down very few big movements, but lots of little movements constrained within a fairly narrow range. In fact, as I was first to demonstrate in 1962 and other economists have since confirmed, prices vary much more wildly than the bell curve. Instead, they follow power-law distributions and change discontinuously. Sharp price swings - crashes and booms - are far more common than the standard models assume, and so large that their effects overwhelm those of all the small changes. Price changes in the past affect markets today; they are not "independent" from one another, as the standard models assume. In short, markets are riskier than generally assumed.

So what? It means that the math behind a lot of the most common financial calculations - how to balance a portfolio of stocks and bonds, how to decide whether an acquisition is priced right, how to hedge a dollar/sterling currency exposure - can be dangerously off-base. It can, for instance, underestimate the risk of going broke by several orders of magnitude. Some of these problems are well-known to the financial pro's; an extensive sub-industry has evolved to "fix" the flaws (for instance, you can buy off-the-shelf software to try to correct the "smile" in an options-price curve.) But many of these fixes are themselves wrong. And the basic theories continue to be standard teaching at most business schools around the world. What's needed is a new start, a new foundation for finance."


Using nothing more than Excel you can confirm for yourself that market variability is not-Brownian.

If I am deciding whether to take  certain risk, it is meaningful to me to learn that the extant description of that risk is wrong. It would be even more useful  to know a better description, but it is still useful to know that the common one is badly flawed.

Another book dealing with this is Nassim Taleb's "Fooled BY Randomness"

These aren't "damn the torpedos, full speed ahead" type books. They are not about staying the course. Instead thay are about descriptions of reality.

Mikey

 

[Marshac]

I agree, he is a very smart individual, no argument there.

Personally, I just felt that this book would have been better off as a 30 page paper rather than a 300+ page book. As I stated earlier, I walked away from the book totally agreeing with the point he was trying to make, so the ideas in the book are good... I just didn't enjoy the book itself.

 

[Jarhead*]

Mikey: Although I have no idea what you are talking about, I am never the less impressed

"I told you, Pa, I need more book learnin"

 

[haha]

Mikey:  Although I have no idea what you are talking about, I am never the less impressed

Jarhead, I was probably just trying to act as if I knew something. Alas, I do not

Mikey

 

[cute fuzzy bunny]

Jarhead, I was probably just trying to act as if I knew something. Alas, I do not

I hope I have served as an excellent role model for you Mikey

Since its well established that market movements in the short term (less than 20 years) are largely driven by psychology than any hard numbers, about all you can reliably do is edge off some volatility with a good quant (see: vanguards AA fund). In the 20+ year timeframes market efficiencies take over and the fundamentals shine through.

But that wont stop people from trying to measure where its going tomorrow or next year. Fruitlessly.

Marshac...how much do you suppose he'd be able to sell a 30 page paper for

Also, anyone besides me finding it amusing to read through parts of books using amazons book index? You read the first xx pages that they let you read, then do a search on a phrase from the last page it allows, which then lets you read xx more pages?

Werner Heisenberg made the observation that the act of measuring something changes the nature of that system- if fractals can be used to predict market trends, then they will alter the market and (probably) negate their usefulness as predictive tools.

Was Schrödinger's cat proposed before Heisenbergs paper?

 

[Marshac]

Also, anyone besides me finding it amusing to read through parts of books using amazons book index?  You read the first xx pages that they let you read, then do a search on a phrase from the last page it allows, which then lets you read xx more pages?

SHHH! Don't give away the secret! I know a few college students using this "feature" to their financial advantage.

 

[Bridget]

TH,

Yes, the market is based on psychology, so I wonder...with all the Prozac and other 'psychological' drugs out there - how would that change the market?

BTW - don't bother analyzing that variable - I'm sure some PhD or snazzy MBA candidate may wish to use it as a thesis/dissertation topic

Actually, I once worked with a schizophrenic - truly diagnosed - and he told me how the drugs they gave him 'shut down' certain pathways in his brain/thinking and creativity - sort of an amplitude modulator/dampener (like depicted in the movie "A Brilliant Mind" - perhaps one could correlate the current market with that.....or perhaps not.

For me, personally, a sure steady approach works best - LBYM and save, save, save.

Regards and 40 winks,

Bridget - aka Deserat

 

[cute fuzzy bunny]

TH,

Yes, the market is based on psychology, so I wonder...with all the Prozac and other 'psychological' drugs out there - how would that change the market?

BTW - don't bother analyzing that variable

Too late!

I think the broad use of antidepressants is responsible for the large shift into index funds, and for the habit of F500 ceos to forget that they're running their company, along with almost every illegal conversation they ever had

I need the dang 40 winks. My wife is getting them right now. I have fussy baby who wants something different every 30 seconds. Hmm...a lot like some investors... :-/