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Cotton, Mandelbrot And Human Fallibility

Written by Paul Amery

  
October 26, 2010 12:21 (CET)

The father of fractals passes away and markets remind us of the limitations of humans’ ability to control things.

It struck me as quite poetic that cotton prices have moved to hit historic highs almost in response to the news that one of the greatest mathematicians of all time, Benoît Mandelbrot, has passed away.

In fact, cotton has jumped by more than 60% in the last three months, according to our sister site, IndexUniverse.com, but it’s in the last couple of weeks that the move has really accelerated.

Mandelbrot made a seminal contribution to financial market theory with his early 1960s study of the price movements in precisely this raw material. He demonstrated that cotton price changes do not follow the bell curve shape of the normal distribution (as classical financial theory assumes), and instead move according to a much wilder trajectory, full of gaps (discontinuities) and extreme movements.

Any trader can tell you that what Mandelbrot said almost 50 years ago describes the reality of financial markets, and not just in cotton or commodities. Unfortunately for all of us, classical economics and finance theorists carried on ignoring Mandelbrot (and receiving Nobel prizes to boot); a great, unstable edifice of financial modelling was constructed on bad theory and we’ve ended up with the colossal financial market crisis of the last few years.

IndexUniverse.eu was lucky enough to conduct an interview with Professor Mandelbrot earlier this year, in which he restated the basics of his theories, as well as reminding me, repeatedly, of the fallibility of human attempts to predict outcomes. “I’ve had a look at your website,” he told me after I had emailed him to request the interview. “It doesn’t seem to be a mathematical journal.” He had assumed that I was editing a publication of a more academic type. Nevertheless, he graciously agreed to spend half an hour on the telephone from New Haven, explaining his understanding of markets with great modesty and patience.

The implications of Mandelbrot’s message for portfolio construction to me seem quite clear: diversify more, much more than you think you need to, don’t seek to predict market movements too much (and thereby overtrade), and, by implication, focus primarily on reducing costs as a way of reducing your chances of losing money. This is a message that is quite contrary to the mindset of most financial market participants, although it’s one that’s more familiar to those in the indexing business. Frenetic, high-frequency trading and unheard-of portfolio turnover levels are still the name of the game for most, however.

There’s surely an unwritten message for policymakers too, whose interference with natural market mechanisms (on the basis of flawed economic models and in the belief that they can control things) has set the stage for the re-emergence of bubble dynamics in commodities and emerging markets, as well as, arguably, bonds. As the policy response to the bursting of the internet mania showed (low interest rates then caused the much larger housing bubble), intervention can produce far more damaging after-effects than those threatened by the original problem. Central bankers now face the unenviable prospect of having to raise rates to contain inflation pressures, even while the financial system remains fundamentally unstable.

 

 




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