Wednesday, October 26, 2005

Mandelbrot: The (mis)Behavior of Markets

Benoit Mandelbrot's latest book is on finance, which is apparently where he started. The book's argument is that markets are less well-behaved than we've been led to believe by the standard financial theories. And by this he means that the "Random Walk" approach, even as it tries to tell us that we can improve our returns by reducing our risk profile, is leaving us open to crashes that happen far more often than the standard theory says. The book presents a pretty convincing case that fractals (what else were you expecting?) are a better model for the behavior of markets than the normal distribution and its bell curve. If market behavior is fractal, then large upswings and large downturns happen much more frequently than you would expect from a normal distribution.

I expected the book to include some hint of how to structure an investment profile for those who bought the basic argument, but that was completely missing. There were hints that major investment firms can find ways to take advantage of Mandelbrot's claim that good and bad events come in bunches, but no indication of how an individual investor with a modest portfolio could do the same, or even where an individual should look for shelter from wild events once you are convinced that they are more frequent than the standard theories say. Modern Portfolio Theory, even while cautioning individual investors that the market is unpredictable, tells you how to allocate your funds to weather the storms.

To some extent, I read the theory as telling us that wild ups and downs are common enough that the gambler's ruin will overtake you much sooner than you would expect even though markets generally trend up, and you can arbitrage away a fair amount of risk by spreading out your bets. If the fractal argument is correct, you need three or four times as many (uncorrelated) stocks in your portfolio in order to average out the expected downturns that can wipe you out. Since the standard model suggests 10 to 30 stocks, the numbers quickly get prohibitive for individual investors to do anything other than invest in diversified mutual funds.

I'm happy to say that this lack of direction doesn't bug me as much this year as it would have a year or two ago. I'm moving most of my investments out of mutual funds and into investment real estate. It does take a fair amount of time to learn how to find, evaluate, and manage properties, but my current belief is that the returns will be better, and that volatility is much lower in real estate than in stocks or mutual funds. But that's not the subject of this review.

If your investments are in the stock market, even if they are in diversified mutual funds, even if they are in broad-based index funds, you should read and understand Mandelbrot's argument. The bottom line is that modern portfolio theory's recommendation to diversify and rebalance regularly is more important than ever.

Filed in:

1 comment:

Anonymous said...

It is hardly news that returns are not lognormal - do a search on leptokurtosis and look at how many results refer to markets.
Anyone who already understood the basics of why diversification is good shouldn't alter their strategy in response to what you've said. The advice to hold 10 to 30 stocks is generally not targetted to a specific estimate of risk. Instead, it reflects the difficulty of finding additional stocks that are uncorrelated to the first 10. Read Swensen's book Unconventional Success if you want to avoid mistakes about diversification.
- Peter McCluskey (