The Hindu Business Line : `Richter scale' for the market

RULE 1: "Markets are risky." How drab that seems, like saying, `winter is cold'. Yet, if the rule is from Benoit Mandelbrot, you better pay heed, for he is the `mathematical superstar' who invented fractal geometry. His new book, co-authored with Richard L. Hudson, is The (Mis)behavior of Markets, from Basic Books (www.basicbooks.com), where you get to see `a fractal view of risk, ruin, and reward.'

Bell-curve has the trappings of a `well-mannered' phenomenon, but price movements don't fit such assumptions, says the wizard.

Standard model finance would assure you that odds of ruin are about 10-20, meaning `one chance in ten billion billion', so "you are more likely to get vaporised by a meteorite landing on your house than you are to go bankrupt in a financial market." Don't be fooled!

For, prices follow a more `violent curve' and that makes an investor's ride "much bumpier," informs the book. Which means, you should `stress-test' your portfolio using computer simulation and play `what-if' before sticking your neck out.

"An aggressive trader can be better prepared to pounce on moments of high volatility. And a prudent market regulator can be more alert to urgent problems — thereby averting financial catastrophes and macroeconomic harm."

By 2007, we may have an early warning system for tsunamis. One wished we had a `Richter scale' of market turbulence too, as some commentators have asked for. Such a measure "would rank market tremors."

Don't forget: Markets are far more risky than the standard theories imagine which is why "so much of the world's wealth remains in safe cash."

Second rule is that trouble `runs in streaks'. There are no isolated arrows, but a whole volley of them; no single bombs, but a carpet. Market turbulence too tends to cluster, write the authors.

This is best watched in `the first fifteen minutes of trading each morning' when in dealing-rooms across the world, "experienced traders, staring at their screens, take the temperature of the market."

Third, "Markets have a personality." Economists speak of endogenous and exogenous effects to refer to factors within and outside. Popular myth is that markets are driven "solely by real-world events, news and people," but no, they have a `durable' internal mechanism too. "Wars start, peace returns, economies expand, firms fail — all these come and go, affecting prices. But the fundamental process by which prices react to news does not change."

Fourth rule can be disheartening: "Markets mislead." Don't be fooled by patterns, warns the fractal guru. Cycles can be pseudo, like godmen; and patterns, spurious. While they may appear `predictable and bankable', realise that "a financial market is especially prone to statistical mirages". Bubbles and crashes need not cause surprise because "they are the inevitable consequence of the human need to find patterns in the patternless."

Last and fifth rule reads, "Market time is relative." We think of clock time, but "trading time speeds up the clock in periods of high volatility, and slows it down in periods of stability."

So, you can mathematically write an equation "showing how one time frame relates to the others" and run it to get the real-life jagged price series. This may explain why `all charts look alike'; unless you read the x-axis, you may not know if the time covered is minutes, months or years. Do dealers need a clock showing `Greenwich Market Time'?

There's an interesting analogy that compares investors to sailors, for both need to weather the storms. While shipbuilders put in great care — to handle not only "the 95 per cent of sailing days when the weather is clement but also for the other 5 per cent, when storms blow," financiers and investors "heed no weather warnings."

Elsewhere, the book discusses `ten heresies of finance', because "much of what passes for orthodoxy in economics and finance proves, on closer examination, to be shaky business."

Looking at the field as an objective observer and a practical man, Mandelbrot finds that finance is a collection of `obvious facts', which perhaps are not so evident for most experts in finance.

So, before saying `markets are turbulent', Mandelbrot prefers to study data collected from a submarine piloted through "the wild crosscurrents, eddies and vortices of Puget Sound".

What he noticed was "a turbulent process that proceeds in bursts and pauses, and whose parts scale fractally." To him, the world economy is `a chamber of mirrors'. "Each company relays, distorts, and attenuates the economic signals as they flash around the globe."

The signals fade over months, years or decades. "Every event, no matter how remote or long ago, echoes across all other events."

Another heresy is that in financial markets `the idea of value has limited value'. The book concedes that there is something called intrinsic value, but this is an over-rated `popular notion'. Value is `a slippery concept', cautions Mandelbrot.

About his book, however, one may not be able to say, `of limited value.'

BookValue@TheHindu.co.in

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