Book Review: The Misbehavior of Markets

 

I met Benoit Mandelbrot at a conference at Columbia University back in early 2001.  It was a conference on the use of fractals in a wide number of subject areas, very few of which dealt with economics.  Mandelbrot was on of the few panelists to include anything on economics, though a few of the biologists gave me some ideas.

As far as I could tell there were only two economists at the conference, and we went out for Indian food together at lunch.  I met Dr. Mandelbrot at the wine reception where we discussed the state of the markets.  He and his friend, George Soros, both feared that Wall Street was mishedged, and that a crisis was coming.

Bright guy, though the eventual crisis was a liquidity crisis, and not a hedging crisis.  But the diversity of people in terms of field of study at the conference helps to explain what drove Mandelbrot intellectually.  He saw analogies across a wide number of phenomena, connected by one main idea — similar power laws.

The book points out the now-well-known fact that price changes are more volatile than the normal distribution will allow.  That has impacts on option pricing and portfolio management.

The book’s criticism of Modern Portfolio Theory, another idealistic creation of economists that neglects real world data is excellent.  From a misdefinition of risk as being equivalent to volatility springs the monstrosity of MPT.

The book shoes many ways where the received orthodoxy of MPT and the efficient markets hypothesis fails.  The only reason these idea hang around is that they are accepted uncritically, almost like a cult.  The chapter on the “Heresies of Finance” is particularly good, and poses problems for much of academic finance.

I liked the book a lot, and think that most academics and practitioners should read it.  It will broaden your horizons, even if you disagree after you have read it.

Quibbles

The main difficulty is this: just because A follows a similar power law to B, does not mean that A & B have something in common.  There are often spurious correlations.

Who would benefit from this book:

Most serious investors and academics could benefit from the book.  It will challenge your preconceptions.  That doesn’t mean that everything Mandelbrot writes is correct, but most of his criticisms of MPT are correct.  The question becomes what to replace MPT with?

If you want to, you can buy it here: The Misbehavior of Markets: A Fractal View of Financial Turbulence.

Full disclosure: I bought the book with my own money.

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5 Comments

  • Keith Piccirillo says:

    “The question becomes what to replace MPT with?”
    Some rhetorical questions.
    How much is the Hurst Componentbeing used and how does Global Tactical Asset Allocation (AlphaSimplex & Cambria) offer a glimpse into the future?
    Behavioral finance is not so easy a caveman can do it.

  • dhom says:

    David, I had the same thoughts when I read the book. The Financial Times conducted an interview with Mandelbrot in 2009, which you may have seen:

    http://www.youtube.com/watch?v=vxbxXBrOPS8

    I think one of the difficulties in contemplating a replacement for MPT is that we no longer have a one-size-fits-all solution. One of the assumptions of the efficient markets hypothesis is that markets are liquid, regardless of the size at which you trade.

    It’s become clear in 2008, if it hasn’t always been clear, that size does matter. Small traders can protect themselves using trend-following and momentum strategies, which have some positive gamma to them. If too many large traders try to do this, we end up with the crash of 1987.

    There are portfolio management strategies already on the shelf now that work well for small traders in fat-tailed markets. I suspect it will be harder for large traders to find something useful.

    David, I’ve thought for a couple of years now that the efficient markets hypothesis is incompatible with a Christian view of total depravity. What do you think about this?

  • cold.as.ice says:

    Are you aware of SIAM – Society for Industrial and Applied Mathematics? They have about a dozen activity groups and journals, Financial Mathematics and Engineering is a new one. A few years ago I followed SIAM resources for Operations Research related topics and found them a tremendous resource.

  • KP — I don’t endorse the Hurst exponent. I am a value investor. I still believe in trolling around for for underpriced, unpopular assets.

    dhom — the efficient markets hypothesis assumes that people are really smart in aggregate, not that they are really good.

    That said, people, and particularly males tend to be attracted to stocks that offer a possible home run.

    I am a strong believer in total depravity, but that only means that everything man does is tainted by sin, not that everything man does is maximally sinful.

    CAI — have not heard of them. Might investigate them more.

  • dhom says:

    Thanks for writing, David. I agree with your distinction between intelligence and virtue as well as the difference between total and utter depravity.

    My understanding of Christian virtue is that belief and action are linked. (Examples would include James 2:8-26 and Romans 1:21). So someone who is very intelligent and yet invests in a way that is inconsistent with his beliefs would not be completely virtuous – though, of course, this doesn’t imply that he’s utterly depraved or even guilty of a sin of commission.

    EMH assumes that people in aggregate are really smart and that they invest in accordance with those beliefs. The market randomly walks and doesn’t exhibit symptoms of crowd behavior.

    But in the Bible, there seem to be numerous examples of crowd behavior on issues with practical utility, such as whether to enter the promised land, whether to worship false gods, and whether to cooperate with the Romans to condemn Christ to death. If indeed we know what’s right and do the opposite, if we do so as crowds and not just as individuals, and the issues affect our rational self-interest, it seems that human depravity is inconsistent with EMH.

    I know other Christians who disagree with me on this. I’m still trying to figure it out and would appreciate some additional input. Thanks for taking the time to help.