In my New Year’s e-letter, I referenced reading Benoit Mandelbrot’s “The (Mis) Behavior of Markets.”
Mandelbrot is perhaps most famous for inventing a branch of mathematics, fractal geometry. His 1962 argument that stock prices vary far more than the standard model allows — that there are “fat tails” — is now widely accepted by econometricians. In 1966, he developed a mathematical model explaining how rational market mechanisms can generate “price bubbles.” He taught math at Yale and Economics at Harvard. He died in October, 2010.
I am only a few chapters in but already want to share four quick quotes and a comment.
“In the real world, causes are usually obscure. Critical information is often unknown or unknowable, as when the Russian economy trembled in August 1998. It can be concealed or misrepresented, as during the Internet bubble or the Enron and Parmalat corporate scandals. And it can be misunderstood: The precise market mechanism that links news to price, cause to effect, is mysterious and seems inconsistent. Threat of war: Dollar falls. Threat of war: Dollar rises. Which of the two will actually happen? After the fact, it seems obvious; in hindsight, fundamental analysis can be reconstituted and is always brilliant. But before the fact, both outcomes seem equally likely. So how can one base an investment strategy and a risk profile entirely on this one dubious principle: I can know more than anybody else?”
“…With such theories [Efficient Market Hypothesis, Gausian distributions, etc.], economists developed a very elaborate toolkit for analyzing markets, measuring the “variance” and “betas” of different securities and classifying investment portfolios by their probability of risk. According to the theory [the one that most large-firm advisors still use], a portfolio manager can build an “efficient” portfolio to target a specific return, with a desired level of risk. It is the financial equivalent of alchemy.” [emphasis mine]“
“Alas, the theory is elegant but flawed, as anyone who lived through the booms and busts of the 1990s [and 2000s] can now see. The old financial orthodoxy was founded upon two critical assumptions in Bachelier’s key model: Price changes are statistically independent, and they are normally distributed. The facts, as I vehemently argued in the 1960s and many economists now acknowledge, show otherwise.”
“By the late 1980s and 1990s, however, I was no longer alone in seeing those flaws. The financial dislocations convinced many professional financiers that something was wrong. Warren E. Buffet, the famously successful investor and industrialist, jested that he would like to fund university chairs in the Efficient Market Hypothesis, so that the professors would train even more misguided financiers whose money he could win. He called the orthodox theory [again, still used by most larger-firm advisors today] “foolish” and plain wrong.”
“But despite recognition of the problem, the old methods have surprising staying-power.”
At Euclid, we do not employ the financial alchemy of Modern Portfolio Theory or the results of its derivative asset allocation programs. We do not ”base an investment strategy and a risk profile entirely on this one dubious principle: that [we] can know more than anybody else.” But as I wrote twice above, most larger-firms and their advisors still do. Why is that? That’s the subject of a future post. Hint: it’s not for the benefit of their clients.
George Home page: www.euclid-advisory.com