I’ve been reading a pretty interesting book over the last few weeks. It’s The (Mis)Behavior of Markets, by Benoit Mandelbrot. The author isÂ probably best known for his work with fractals, but has been researching financial markets on and off since the 1960s.Â I picked up the hard copy edition during a bargain book sale after the holidays using one of the several gift cards I received, and have been reading it on my commute.
First, a warning. This is not a book that’s going to teach you how to predict the markets. If you’re looking for that kind of book, look elsewhere. In fact, if you’re looking to learn about trading or investing in the markets, this is probably not a good book for you. This is not an overly practical book in terms of providing any methods or techniques for use in your day to day trading.
The (Mis)Behavior of Markets is much more along the lines of a scholarly discussion of prices. For those with a desire to understand how prices move, this is a good book. In particular, it’s great for understanding why it is that even the supposedly best and brightest (like Long-Term Capital Management – LTCM) could get it so wrong. In short, much of what university economics and finance departments have been teaching for years is at best misleading and at worst dangerous.
I must state for the record that I have long held a less than agreeable view toward efficient market theory, Black-Scholes, random walk, and all of that stuff. It goes back to my days as an undergraduate finance student when I just intuitively didn’t believe what I was being told and often saw the major flaws. When I started working in the markets I saw first hand how ridiculous many of the underlying assumptions behind classic financial theory really are. In The Essentials of Trading I presented some of the basic ideas, but also indicated what I saw were the major issues.
In The (Mis)Behavior of Markets, Mandebrot takes on classic financial theory in a very straightforward manner. He is extremely critical of the way economic (and by extension financial) theoryÂ has beenÂ developed and moved forward. He spends a fair amount of time explaining how the now classic theories of price movements came about, which I found interesting since I’m a bit of a history buff.
From what I understand, many of the things that I used to gripe about with my professors as being major flaws in classic finance have finally been recognized in recent yearsÂ by academia as just that. This from a professor friend of mine. I don’t know whether or not things have changed in what’s being taught, though. My impression is not so much, which to me seems a major disservice.
The thing I found most interesting in the book was how all these theories have been torn apart, not just recently, but for decades. Mandelbrot and others figured out very early on that price changes do not conform to a normal bell shaped distribution. They also figured out that price changes are not independent. Those are two major capstones underlying efficient market and random walk theories and the pricing of options using Black-Scholes.
The thing that really irks me is that none of these critiques were ever presented to me in the classroom. We were just taught the same stuff that had been taught for years and years with no perspective on how research was showing major problems.
The biggest thing Mandelbrot focuses on in terms of the implicationsÂ of all the erroneous assumptions is the implied risk. He points out that things like the Crash in 1987 should literally never have happened according to classic theory, and that otherÂ market shocksÂ in recent years were also so improbable as to be beyond the reasonable expectation of classical theory. Given how many securities are priced using models based on that classical foundation, and how the commonly employed Value at Risk (VAR) calculations are similarly based,Â you can see how this is a major problem. Investors and institutions have been taking much more risk than they thought. This is something which once again became readily apparent last summer as the credit crises exploded.
Mandlebrot, naturally, presents a different way of looking at price movement – one founded in his fractal theories. He readily admits, however, that it is still early in its development. Much more work and research needs to be done. One cannot use anything he presents in the book to help forecast prices, though it can help to understand better how prices move, and thus by extensionÂ the risk of financial assets, which is a benefit of potentially enormous value on its own.
All in all, I would call The (Mis)Behavior of Markets a good read. It’s informative and thought provoking, but doesn’t bog the reader down in a great deal of math and complexity (there’s an appendix for those inclined in that direction). If you are at all intellectually curious about the financial markets, this is definitely a book worth reading.