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The Misbehavior of Markets

A Fractal View of Risk, Ruin and Reward

By Benoit Mandelbrot and Richard L. Hudson
15-minute read
Audio available
The Misbehavior of Markets: A Fractal View of Risk, Ruin and Reward by Benoit Mandelbrot and Richard L. Hudson

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.

  • 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

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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The Misbehavior of Markets

A Fractal View of Risk, Ruin and Reward

By Benoit Mandelbrot and Richard L. Hudson
  • Read in 15 minutes
  • Audio & text available
  • Contains 9 key ideas
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The Misbehavior of Markets: A Fractal View of Risk, Ruin and Reward by Benoit Mandelbrot and Richard L. Hudson
Synopsis

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.

Key idea 1 of 9

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!

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