The Misbehavior of Markets | Benoît B. Mandelbrot

Summary of: The Misbehavior of Markets: A Fractal View of Financial Turbulence
By: Benoît B. Mandelbrot

Introduction

Welcome to a fascinating journey through the world of financial markets, as explored in Benoît B. Mandelbrot’s ‘The Misbehavior of Markets: A Fractal View of Financial Turbulence’. In this book summary, you’ll discover how traditional economic theories, based on assumptions of rationality and smooth transitions, fall short in capturing the true nature of market behavior. Instead, Mandelbrot proposes the use of fractal geometry, a mathematical approach that embraces the inherent roughness and complexity of markets. Key topics covered include the limitations of orthodox financial theories, the power of fractal geometry, and its successful application in contemporary trading strategies. Just as nature shows complex patterns, so do the financial markets, and a better understanding of these patterns can lead to more accurate predictions and investment decisions.

The Myth of Rational Investing

The concept of homo economicus, the idea that investors behave rationally to maximize their utility, has been a mainstay in finance for over a century. Mainstream theories of finance assert that investors will always choose the most profitable, obvious rational choice. However, research has shown that investors often behave irrationally due to their tendency to misinterpret information and misjudge probabilities. This means that investors need to acknowledge their irrational behavior to make better investment decisions.

Economic Theories and Investment Strategies

The book challenges mainstream economic theories of finance, stating that they are based on oversimplified assumptions about human behaviour. It critically evaluates the Chicago School’s Neoclassical theories, which assume that all investors have the same goal of making as much money as possible and hold their stocks for the same period. In reality, investors have different investment goals, time horizons, and follow vastly different strategies. Some are growth investors who buy stocks in companies that are experiencing rapid growth, while others prefer investing in mature and stable companies with slow-but-steady growth. The author questions whether mainstream economic theories, based on oversimplified assumptions, create bad predictions about market behaviour, leading to poor investment choices.

The Flaws in Orthodox Financial Theory

According to orthodox financial theory, prices are assumed to follow a normal distribution pattern where small price changes are much more frequent than large ones. However, this assumption is flawed. Prices do jump, and this phenomenon cannot be explained by normal distribution.

One reason for this is that currency brokers tend to round decimal values, which results in overestimating the magnitude of a jump. Additionally, order imbalances, caused by situations such as large amounts of buy orders with few sellers, can lead to sudden price spikes. Big news, such as the FDA’s approval of a new drug, can also cause hordes of people to rush and buy a particular stock leading to a large price jump.

In conclusion, orthodox financial theory is rooted in flawed assumptions, and there is a need to develop alternative models that can better explain the complexities of the market.

The Foundation of Modern Financial Theory

Louis Bachelier’s probabilistic model presented in his doctoral thesis at the Sorbonne would ultimately become the foundation of modern financial theory. His theory contradicted the idea that prices move in predictable patterns and suggested that they move randomly and independently. However, several empirical studies have shown that prices do follow trends, which can be caused by major news leaks or other factors. Campbell Harvey’s study found that stocks that rose over a five-year period are more likely to fall in the next five years. Thus, the mainstream theories of finance are unconvincing, and economic development needs a better and more precise description.

Embracing the Roughness

In the past, scientists considered irregularities as exceptions to smooth shapes or graphs. However, many natural and market processes are inherently rough, not smooth. Mainstream financial theories strive to impose smoothness on market dynamics, but they can’t match up to reality. Theories that accept the market’s roughness are more accurate and helpful. Fractal geometry, a unique kind of regularity that exhibits self-similarity, provides a solution for managing the roughness. Fractals are found not only in vegetables like Romanesco broccoli but also in wind turbulence and financial market behavior. By embracing the roughness, we can better understand and manage complex and seemingly chaotic phenomena.

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