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Name: The Misbehavior of Markets
Rating: 4.3 (80 reviews)
Author: Benoit Mandelbrot and Richard L. Hudson

Benoit Mandelbrot Richard L. Hudson

A Fractal View of Risk, Ruin and Reward

4.3 (80 ratings)

18 mins

Brief summary

'The Misbehavior of Markets' by Benoit Mandelbrot and Richard L. Hudson is a unique perspective on financial markets, offering insights into their unpredictable and chaotic nature. The book argues for a new approach to understanding market behavior.

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Investments Mathematics Economic Theory

Table of Contents

The Misbehavior of Markets
Summary of 8 key ideas

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Key idea 1 of 8

What’s in it for me? Discover why economic orthodoxy has failed – and what we can do about it.

Mainstream financial theories offer precise, comprehensive and self-contained models of financial markets. Yet, all around the world, those same financial markets occasionally undergo massive collapse that stays completely hidden from mainstream analysts until it’s too late.

We only have to look back as far as the financial crisis of 2008 to know that markets are far more irregular and volatile than our current economic models would otherwise claim.

Luckily, there is an alternative approach, fractal geometry, that can be used to look for ways to reckon with the inherently rough nature of changes in the market, rather than viewing these changes as anomalies or trying to force them into neat and convenient models.

In these blinks, you’ll find out:

how conventional economic theories view us all as Lieutenant Commander Data;
what Romanesco broccoli and market trends have in common; and
how one company doubled its net capital by abandoning certain market principles.

We’re considerably less rational than mainstream theories of finance suppose.

If you’ve ever seen Star Trek, then you surely remember the unforgettable android, Lieutenant Commander Data. As a completely rational being, Data often struggles to understand the strange behavior of his human crewmates.

According to dominant theories in finance, every investor can be seen as Data.

This is nothing new. In fact, the concept of the homo economicus, i.e., completely rational agents striving only to maximize their utility, was introduced by John Stuart Mill in the mid-nineteenth century, and since then it’s been a mainstay in orthodox economic theory.

Mainstream theories of finance, like those of the Chicago School, contend that each individual will make the most profitable, obvious rational choice. With enough relevant information about a particular stock, there will be one choice which will yield the greatest profit, and this is what we’ll choose.

For example, if the stocks of one Venezuelan bank perform better than competitors in the past month, then it seems like the best investment that a completely rational, self-interested and informed investor could make.

In reality, however, we don’t always behave rationally – even investors. In part, our irrational behavior is due to our entirely human tendency to misinterpret information and misjudge probabilities.

Take this experiment, for example, in which participants were given the choice to either collect $100 immediately or flip a coin and win $200 for heads and nothing for tails. Unsurprisingly, most people opted to collect the free $100.

Then, the rules were altered: now, people had to choose between paying $100 or flipping a coin and losing $200 for heads and nothing for tails. This time, most people decided to gamble.

Objectively, the potential wins and losses were the same, so any rational person should make the same choice under both conditions. But we’re irrational, and so most people acted as if the odds for both games were different.

As we’ll see, investors are not rational automatons. They misinterpret information, miscalculate probabilities and let emotions distort their decisions – just like everyone else!

The orthodox theories of finance wrongly assume that all investors follow the same strategy.

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.

Contrary to widespread assumptions, prices jump significantly in value from one moment to the next.

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.

Despite the assertions of orthodox economics, changes in price are not independent from each other.

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.

Some things are naturally complex and “rough,” so the tools to explore them must be fit for roughness.

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.

The dynamics of the market are best described as a fractal phenomenon.

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.

An adequate theory of real markets doesn’t measure time with a clock.

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.

Today, some economists are implementing fractal geometry for their analyses.

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.

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What is The Misbehavior of Markets about?

The financial theories you learn about in school are coherent, neat, convenient – and wrong. In fact, they’re so wrong that they might also be dangerous: in underestimating the risk of markets, we inadvertently set ourselves up for catastrophe. The Misbehavior of Markets lays out the flaws of economic orthodoxy, and offers a novel alternative: fractal geometry.

The Misbehavior of Markets Review

The Misbehavior of Markets (2004) explores the fascinating world of financial markets and challenges traditional theories of predictability. Here's why this book is worth reading:

With its groundbreaking insights and analysis of financial data, it offers a fresh perspective on market behavior, revealing the inherent unpredictability of the financial world.
Benoit Mandelbrot, a pioneer in fractal geometry, brings his expertise to the field of finance, offering a unique blend of mathematics and real-life application.
The book confronts the conventional wisdom surrounding financial markets, presenting a compelling argument for embracing uncertainty and managing risk effectively.

Best quote from The Misbehavior of Markets

People simply do not think in terms of some theoretical utility measurable in dollars.

—Benoit Mandelbrot and Richard L. Hudson

Who should read The Misbehavior of Markets?

Anyone who’s involved in finance
People wondering whether it's wise to put their finances in someone else’s hands
Those who find fractal images mesmerizing

About the Author

Benoit B. Mandelbrot was the world-famous inventor of fractal geometry as well as a Sterling Professor of Mathematical Sciences at Yale University and Fellow Emeritus at IBM's Thomas J. Watson Laboratory. Mandelbrot won numerous prizes, including the Wolf Prize for Physics, and wrote several books, such as the bestseller The Fractal Geometry of Nature.

Richard L.Hudson is a leading European science and technology journalist as well as former managing editor for The Wall Street Journal Europe. He is now CEO and Editor of the London-based media company Science Business Publishing, Ltd.

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