Benoit Mandelbrot, the famous mathematician and inventor of fractal geometry, has forever changed the way we understand many natural phenomena, and influenced a host of modern fields from chaos theory to the financial markets.
Before Mandelbrot, the modern theory of finance used in most existing investment models, was based on the following shaky assumptions:
People make rational assumptions.
When given all the relevant information about an investment, individual investors will make the obvious rational choice leading to the greatest wealth. This will result in an efficient market, with all prices at their "correct" level. Rational investors make for a rational market.
In Reality, behavioral economics show how people are hardly ever rational and self-interested.
All Investors are alike.
People have the same investment goals and hold their investments for the same periods. With the same information, investors will make identical decisions. Thus a model that describes one investor describes them all.
In Reality, people are not alike. Without homogeneity, the mathematical models of the market become very complicated. The market changes from a well- behaved system, with predictable outcome, to a chaotic one with unanticipated results.
Price Change is more or less continuous.
Stock prices always move smoothly from one value to the next.
In Reality, this smooth stock movement is interrupted by sudden jumps all the time.
Each price change is independent from the last
and the process generating these price changes stays the same over time.
In Reality, life is more complex and markets do have a memory, i.e. what happens now will be reflected in behavior far into the future.
Based on chaos theory and fractal geometry, Mandelbrot describes the characteristics of the markets as follows:
1. Markets are Turbulent
Their behavior can be compared to the behavior of flowing fluids when reaching certain speeds. The same kind of turbulence happens in the financial markets with abrupt lurches between mild motion and quiet activity, discontinuities, and concentrations of major events in time.
2. Markets are very risky
Turbulence is dangerous. Its output can swing wildly and suddenly. It is hard to predict, harder to protect against, and hardest of all to profit from.
3. Market Timing is very important
Big gains and losses occur into small packages of time. Concentration of major events, and volatility, is common.
4. Prices often leap, not glide
That financial prices often jump, skip and leap up or down ads to the investment risk.
5. In Markets, Time is flexible
The same risk factors apply to a day as to a year, an hour as to a month. Only the magnitude differs, not the proportions. That's why charts with different time scales look the same.
6. Markets in all Places and Ages work alike
One of the surprising conclusions of fractal market analysis is the similarity of variables from one type of market to another. Also, the patterns, in space or time, remain the same even as the scale of observation changes. Finding market properties that remain constant over time and place means you can make better, more useful models and make sounder financial decisions.
7. Markets are Deceptive
Price changes may be persistent and reinforce each other, i.e. a trend once started tends to continue, or the trend once started may reverse. Persistent trends appear to display long, slow, up-down cycles of three.
9. Volatility clusters
Large price changes tend to be followed by more large changes up or down, and small changes by more small changes up o or down.
10. In Financial Markets, the Idea of "Value" is useless
What is the value of a company, and how does this number correlate with the price of its shares? There seems to be no correlation, no matter how you define this value.
CONCLUSIONS
How do we thrive in such an existentialist world? People make money in the markets all the time.
Based on the new chaotic, fractal model of the markets, here follow the most important ideas to adhere to when investing in the financial markets:
What really counts are price differences
not value or price. The only thing to keep in mind is that, to make money, your selling price has to be higher than your buying price and, obviously, the greater the difference in these two prices, the bigger your profit. Thus the general idea that you should "buy low and sell high" is really misleading since it entices investors to waste a lot of time finding low priced stocks with a potential of moving higher. Any stock, at any price, has the potential to move up or down! Thus the stock price is not a criterion in trade selection.
A Trend once started tends to keep going
There is a long-range dependence in price changes of a particular size and direction. The changes can be persistent and thus reinforce each other. In this case a started trend will keep on going. Thus an investor should look for strong trends with large price changes.
Reversals can happen any time
Sometime the price changes are anti-persistent and a trend in one direction may reverse itself. Also, any trend will eventually come to an end. Such events are not predictable and an investor should confirm that the stock he wants to buy is still moving in the right direction prior to pulling the trigger and, once in the market, always use stops.
The "Buy and Hold" Strategy is Dangerous
Many financial advisers and stock brokers always seem optimistic about the stock market and promote the buy and hold system whereby you buy a stock- usually on their recommendation- and hold it for many years. Since the risk is independent of the time scale, long-term investing is just as risky as short-term investing, but the magnitude of potential losses scales with time. Therefore the risk of ruin with a long-term commitment is much greater than with a short-term exposure to the market.
PUTTING IT ALL TOGETHER
To make money in the stock market, buy (or short sell) stocks in a strong trend with a strong momentum (a stock with big price changes in one direction). Place a tight stop to minimize a potential loss and continuously adjust your stop to protect your gains. Get out at the first reversal.
This Stock Trading method will give you an excellent chance for profit with the least exposure to the market and thus minimum risk.
Since the markets are inherently risky, it is prudent to only use at most 50% of your discretionary money for stock market trading and no more than 5% of your investing capital on any position. |
