Mandelbrot Suggests A Hunt For Financial Patterns

Phoe6 writes "Wired is carrying an Open Letter of Benoît Mandelbrot, the father of the fractal, to the wizards of Wall Street, calling on them to recognize a pattern in the finantial and economic trends in the world. Mandelbrot says, If we can map the human genome, why can't we map how a man loses his livelihood? If millions can contribute a few cycles of their PCs to the search for a signal from outer space, why can't they join a coordinated search for patterns in financial markets?" I'd like to see a debate between Mandelbrot and Friedrich Hayek.

Comments

Re:And what if we DID map it?

[wfberg]

The stock market in fact has a wealth multiplying effect, as all financial markets do: the "money" you have in $100 Yahoo shares isn't sitting in a bank account somewhere, but is instead being used by Yahoo to invest in other companies (through stock swaps), is being loaned to companies to make capital investments, is being used as collateral by individuals, etc.

You're wrong in two ways;
1) Money does not sit dormant in a bank account. It gets loaned out or invested by the bank. Banks can lend out (usually in the form of mortgages, overdraughts and credit) or otherwise invest money held in their accounts for up to 90%.

2) Money is only injected into companies like yahoo to actually invest when they issue new stock.
Stock-swaps are basically using monopoly money to buy monopoly money, and aren't captical investments anyway. Post-IPO gains in a stock's price doesn't put money into the corporation's hands.

And you're kind of wrong in a third way too; if I buy $100 of Yahoo stock post-IPO, I'm buying them from some other guy who might be using that money to invest elsewhere.

On the whole, the money that is tied up in the markets (in the form of shares held by investors) isn't doing much "work"; over the long term it's comparable to a savings account.

If your aim is to stimulate the economy, you'd be better off spending money on high risk ventures that don't have as much of a zero-sum nature; e.g. venture capital, small (starter) business loans, junk bonds, etc.

The markets reflect how well the overall economy is doing mostly on account of the fact that people don't throw money into the market if they need their cash to feed hungry mouths. Other than that they only reflect how well a company or a bunch of companies is doing relative to others.


Bottom line: stop talking out of your ass about something you clearly know nothing about.
You said it.

He's talking about dynamics, not prediction!

[IntelliTubbie]

(Note: I have degrees in mathematics and finance.) Mandelbrot is not talking about making price predictions in the stock market, e.g. "if the price goes up on Monday, it will go up on Tuesday". As many ./ers have already noticed, any such scheme would be self-defeating: if people began to anticipate a Tuesday price rise, they would buy on Monday, driving the price up a day early -- and erasing the pattern.

For this reason, most financial models assume that stocks follow a kind of stochastic (i.e. random) process called a "martingale", meaning that returns are uncorrelated over time, so you can never beat the market with a strategy like the one above. However, this leaves open the question of which probability distribution the returns follow.

The earliest models, such as the Black-Scholes model for option pricing, assume that stocks follow geometric Brownian motion -- this means that returns follow a normal probability distribution, i.e. the usual bell curve. However, real world markets do not follow a normal distribution: the tails of the distribution are much "fatter", meaning that the Black-Scholes model underestimates the risk of extreme market moves. Therefore, this is a bad risk model, and a company full of Nobel prize winning PhDs, called Long Term Capital Management, followed it off a cliff in the late 90's, nearly bringing down the US financial markets. (For a captivating account of LTCM's rise and fall, check out the book "When Genius Failed".)

This is what Mandelbrot means when he "encourage[s] the study and adoption of more-realistic risk models". We need a better model for the statistical dynamics of markets in order to properly understand (and price) risk -- i.e. to be able to compute accurately the probability that such-and-such price move will happen -- not to make simple-minded stock predictions.

If you're interested in Mandelbrot's own mathematical work on the subject, I'd recommend his book "Fractals and Scaling in Finance". For a great read about the inherent unpredictability of the markets, try the books "A Random Walk Down Wall Street" or "Fooled By Randomness".

Cheers,
IT