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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.
Considering that Hayek has been dead for over 10 years, I think that debate would definitely be worth seeing.
Mandelbrot watches Pi, has idea...
Are you familiar with Elliot cycles? Probably not. He came up with an idea like this around a decade ago. (Reading back issues of NewScientist can do wonders for you knowledge like this.) These ideas keep getting thrown around but never come to fruition because at their core they are inaccurate. As simple as that. Whether it's based on power laws, or assumptions about the nature of price spikes (up-up-down-up-up-down), trying to reduce markets to mathematical patterns invariably fails.
8:14 read slashdot /. is the language of nerds.
8:15 restate my assumptions:
1.
2. Everything around us can be represented and understood through discussion threads and trolls.
3. If you graph these numbers, karma emerges.
Therefore: There are karma whores everywhere in nature.
8:17 Press Submit
If we can map the human genome, why can't we map a man's 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 in a coordinated simulation of Friedrich Hayek?
Let me recap Mandelbrot's point here.
In the April 2003 settlement of postbubble fraud charges, the biggest Wall Street firms agreed to cough up $432.5 million to fund "independent" research. Mandelbrot then makes the distinction between two kinds of research. One is the kind of research where analysts study a publicly traded company, and then give recommendations to buy, sell or hold. The other kind is fundamental economic research.
Mandelbrot then suggests that at least five percent of the settlement money be directed toward fundamental research. He does not say that we should look for a way to predict the markets with absolute certainty - that would be impossible, as many here have redundantly pointed out. (He would probably be insulted to know that so many here think that's what he advocated. He's not stupid, you know.)
He's talking about giving a boost to the kind of fundamental economic research that's already taking place. Stuff like risk management, for example. If you read the article, maybe you noticed that in the beginning he clearly gave examples of what's wrong with our present models in risk management.
That financial markets are stochastic is an assumption - with extreme levels of 'deterministic noise' it can appear stochastic - a small difference when specifying an equation to predict a future level can make a massive difference: this is chaotic. Stochastic modelling works OK because of the large levels of noise, most modern finance is built on the assumption errors are Gaussian, a framework formalised in the 60s but assumed even earlier. Sadly today anyone can trot out a Black Scholes thesis, support the group think in academia, and get a PhD from a decent institution (a disease in many disciplines other than economics/finance).
Think of financial markets like the weather - tomorrow is more likely to be the same as today, some minor variance, but saying it is going to be largely similar will mean you're right most of the time: this doesn't help pedict a storm. Likewise tomorrow the stockmarkets will likely be the same as today, but this doesn't help predict a crash. As weather the stock market model can be refined, but in the end it is chaotic and hugely deterministic (many agents looking at each other and others actions).
Many agents looking at each other's actions is important - the market does not exist without agents (buyers/sellers) - it is an endogenous process. A co-operative solution will not work - someone always has to do worse for anyone to do better than the market - the market and the economy is just the sum of the actions of participants, participants cannot move against the market as they, in sum, are the market. Calling on the market to recognise a pattern is folly - a small participant can take advantage of any pattern if discovered, but the market as a whole cannot because if they stop their present action to follow/takeadvantage of/neutralise the pattern they have stopped taking action that creates the pattern.
Patterns in financial markets have long been looked into, a good starting point on current thought, if interested, is technical analysis and elliott-wave theory
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.
SCO employee? Check out the bounty
(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
Power corrupts. PowerPoint corrupts absolutely.