Do markets really follow a random walk as modern financial theory suggests? Are we likely to experience a market crash as deadly as the likes of the Great Depression? What is the nature of volatility and how should it impact the way we model financial markets? Although definitive answers to these questions have yet to be formulated, Benoit Mandelbrot's work, The (Mis)Behavior of Markets, sheds light onto them through a non-quantitative approach.
There are currently widespread misconceptions about markets, investors, and their behavior, and we will begin by addressing these false assumptions.
[...] With the discovery of a new mathematics, Mandelbrot has been able to closely imitate market behavior. Through his multifractal model, he fools a chartist by generating a fake price series. From his model, he deduced certain rules by which markets govern themselves. Rule Markets are risky. Standard models underestimate the wild price swings that occur within the market. These models are of course a reflection of modern theory that suggests that prices follow a mannered” bell curve. Rule Trouble runs in streaks. [...]
[...] Bluntly put, a price variation of yesterday will into the behavior of prices today and tomorrow. Today's models falsely assume the financial system is a “linear, continuous, rational machine.” Turbulence translates into risk, and “markets are very, very risky more risky than the standard theories imagine and conventional finance ignores this” (230). Risk is measured by volatility that is quantified by the bell-curve standard deviation. With the conventional system we are looking at average stock-market earnings, and this method claims that the risk premium should not be in excess of one percent. [...]
[...] Comparing two segments of time, one from a period of high volatility and one from a period of stability, Mandelbrot's model shows that the period of volatility is simply a contraction of the stable period. Let us revisit an innate quality of markets: turbulence. After having listened to the sounds of water turbulence that a submarine recorded in the depths of the Puget Sound, Mandelbrot observed a fractal-type sound recurrence. The connection between water and market turbulence hit him: That experience underlies all my thinking about financial markets. [...]
[...] It has a set of numbers a multifractal spectrum that characterizes the scaling. It has a long term dependence so that an event here and now affects every other event elsewhere and in the distant future. The scaling effect is present in every level of business operations. Let us take an industry that relies heavily on the weather, such as harvesting. As the weather has a direct affect on the availability of harvests, this in turn will have an affect on supply that further will affect the prices. [...]
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