The Misbehavior of Markets summary

Even if investors made rational choices all the time, would that mean that the same choice is rational for every investor? According to orthodox economic theories, yes.

Many of these orthodox theories are rooted in the works of notable economists, like those from the University of Chicago’s Chicago School, a Neoclassical group that produced and attracted many Nobel laureates.

According to orthodox financial theory, prices don’t jump – rather, they glide. The assumption is that when prices increase or decrease, they are bound by normal distribution, i.e., the tendency for variations to stay close to the mean. The farther a value is from the mean, the rarer it will be.

For example, body height follows normal distribution. In the US, men’s heights cluster around a mean of 70 inches.  In terms of percentages, 95 percent of American men are between 66 and 75 inches tall, and 98 percent between 64 and 76 inches.   

The math professors at the Sorbonne in Paris weren’t thrilled when Louis Bachelier presented his doctoral thesis in 1900: rather than exploring something lofty and traditionally academic, like complex numbers, Bachelier worked out a probabilistic model analyzing the money-grabbing speculations at the Paris exchange in order to evaluate stock options.

Despite his professors’ disappointment, Bachelier’s model would become the very foundation of mainstream financial theory some 70 years later.

In the past, scientists treated irregularities as exceptions to the rule – little more than meaningless aberrations from a perfect shape or graph. Think back to those normally distributed price movements: economists visualize them as adhering to a smooth bell curve. Consequently, extreme changes in price – that deviate from the curve – are seen as simple anomalies.

However, many phenomena and processes in both markets and nature are inherently complex, irregular or rough, and not smooth like a bell curve.

In 1961 Harvard professor Houthakker was immensely frustrated: the New York cotton exchange had kept meticulous price records for a century, yet despite his best efforts, Houthakker simply couldn’t fit the data on the cotton market into Bachelier’s model.

The cotton market, far from being smooth, was extremely rough. In fact, financial records report enormous surges and plunges in price – far too many to be considered part of a normal distribution.

Surely you’ve experienced variance in the passage of time, when it creeps along like molasses during a boring meeting yet flashes by in an instant when you’re out with an old friend. In those cases, the way you experience time is wildly different from what it might say on a clock.

The same holds true for markets: time, as measured by clocks, is ill-suited as a tool for understanding market behavior.

In theory, you could argue that fractal geometry is a better tool for describing markets than the standard theories of finance founded on Bachelier’s model, normal distribution or concepts of human beings as homo economicus. Yet, as of today there’s no comprehensive economic theory based on fractal mathematics.

Nevertheless, some labs, financial providers and consultant firms employ these models. For instance, the financial provider Oanda, who offers an online currency conversion platform in addition to information on foreign exchange, uses fractal analysis for its services.