The (Mis)Behaviour of Markets | Benoît B. Mandelbrot

Summary of: The (Mis)Behaviour of Markets: A Fractal View of Risk, Ruin and Reward
By: Benoît B. Mandelbrot


Embark on a thought-provoking journey with Benoît B. Mandelbrot in his book ‘The (Mis)Behaviour of Markets: A Fractal View of Risk, Ruin and Reward,’ where he challenges the conventional financial theories and offers new insights into understanding the complexities of markets. Dive into the world of fractals, the science of roughness and self-similar patterns that govern various phenomena, including stock prices. Grasp Mandelbrot’s Ten Heresies of Finance that defy traditional financial wisdom and explore how multifractal models bring us closer to understanding real-world market behavior. Finally, discover the potential of fractal mathematics in refining investment analysis, portfolio management, option valuation, and risk management.

The Unconventional Genius of Benoit Mandelbrot

Benoit Mandelbrot’s childhood prepared him to accept the possibility of the unthinkable, which enabled him to see similarities and connections among phenomena that seemed unrelated. Mandelbrot was a maverick who withdrew from the elite Ecole Normale Superiore to study at various institutions. He took a scientific interest in the study of markets, cotton prices, risk, stock market bubbles, and other economic phenomena. Mandelbrot believed that conventional finance models violate the Hippocratic Oath to “do no harm” and that they are not only wrong but dangerously so. His contributions to the field of economics sometimes threatened the foundations of the discipline. Price movements in finance do not follow the well-mannered bell curve assumed by modern finance but follow a more violent curve that makes an investor’s ride much bumpier. Mandelbrot’s father was one of the prisoners who managed to cheat death during World War II. His extraordinary mathematical intuition was discovered while hiding in a school in Lyons, where sympathetic benefactors provided him with false documents and ration cards. Mandelbrot’s ability to see immediately the truths that others could only reach after a long struggle and elaborate proof was remarkable. The simplest fractals scale the same way in all directions and are called self-similar, while multifracta scale in different ways at different points, making their mathematical properties intricate and powerful.

The Ten Heresies of Finance

In his book, Mandelbrot challenges the conventional orthodoxy of finance by introducing what he calls the “Ten Heresies of Finance.” Mandelbrot argues that the accepted financial theories fall short in capturing the full range of market risks. He highlights how markets are like roiling seas with turbulence where scaling, long-term dependence, and value play a significant role. Mandelbrot goes on to explain how market timing, which is often viewed unfavorably by brokers and financial advisors, makes sound sense. He emphasizes how prices do not move slowly and steadily, but they often move discontinuously, with a big jump. Mandelbrot argues that markets are not the same always and everywhere, and bubbles are inevitable. He challenges the belief that markets are rational and that patterns can show meaningful information. Finally, he emphasizes that volatility is easier to predict than prices and that value is not worth much in financial markets. Overall, this book is a critical read for anyone interested in understanding the intricacies of financial markets.

The Fractal Revolution in Finance

The book explores the emergence of risk as a financial priority in the 1960s and the work of French mathematician Louis Bachelier, whose mathematics of probability analysis enabled the study of price changes in the Paris Bourse. Building on this work, Eugene F. Fama developed the Efficient Markets Hypothesis, which posits that prices incorporate all relevant information and change solely in response to new information. The hypothesis is one of three legs supporting contemporary financial orthodoxy, the other two being the statistical mathematics of Harry Markowitz and William F. Sharpe. However, these scholars’ work is not without flaws and can be patchy. Critics such as Mandelbrot argue the orthodoxy’s assumption that randomness is the foundation is problematic. Further, the orthodox theorists and practitioners’ reliance on obsolete and deficient theories and patches have brought the world close to financial disaster on numerous occasions. The book posits that the financial world needs a new model: the multifractal model, which finds the simplest explanation for the widest range of phenomena.

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