Thread by @jsmian

1) As we try to unscramble the complexity of markets, we are always seeking a measure of order from the apparent randomness.

It is interesting to us how markets (mis)behave. As Benoit Mandelbrot said, the chaos and irregularity of the world is something to be celebrated.

2) A self-described “wandering scientist,” pursuing what he called “unpredictable interests,” Benoit Mandelbrot moved across many disciplines at once to find new insights.

3) He spent much of his life as an outsider, seeking to extract an element of order in physical, mathematical, or social phenomena characterized by wild variability.

4) Behind the veil of apparent complexity, Mandelbrot recognized that many of the seemingly disordered patterns of nature are highly ordered, following simple rules.

5) He coined the term “fractals” in 1975 to describe a geometric shape that can be separated into parts, each of which is a reduced-scale version of the whole.

6) For instance, the veins in leaves look like branches; branches look like tiny trees; and rocks look like miniature mountains.

The same repeating patterns can be seen in snowflakes, rivers, broccoli flowers, and systems of blood vessels.

7) According to Mandelbrot, the geometry that describes the shape of coastlines and the distribution of galaxies throughout the cosmos also elucidates the variability of markets.

“The very heart of finance is fractal,” he said.

8) The movements of a stock all look alike when the chart is enlarged or reduced to fit the same time and price scale.

Patterns on intra-day charts of minutes or hourly intervals are very similar to the patterns seen on the daily, weekly, monthly or even quarterly charts.

9) Mandelbrot saw financial markets as an example of “wild randomness.”

“Markets, like oceans, have turbulence,” he said. “Some days the change in markets is very small, and some days it moves in a huge leap. Only fractals can explain this kind of random change.”

10) Standard models overlook the psychological complexity of men and women acting on their fleeting expectations of what may or may not happen, “sheer phantasms” as Mandelbrot put it.

11) Here are Mandelbrot’s five rules of market behavior.

1. Markets are risky: Extreme prices swings are the norm, not aberrations that can be ignored.

Prices do not follow the well-mannered bell curve, rather a more violent curve that makes an investors’ ride much bumpier.

12) 2. Trouble runs in streaks: Big or small price changes are followed by more of the same kind.

Market turbulence tends to cluster.

Mayhem in one market spreads instantaneously to all others—and we only have vague of notions how this happens, or how to regulate it.

13) 3. Markets have a personality: Prices are not solely driven by real-world events, news, and people.

When all sorts of investors come together in a real marketplace, a special, new kind of dynamic emerges—greater than, and different from, the sum of the parts.

14) 4. Markets mislead: There are spurious patterns and pseudo-cycles that appear predictable and bankable. But markets are prone to such statistical mirages.

Bubbles and crashes are inherent to markets.

15) 5. Market time is relative: There is what one may call a relativity of time in financial markets.

Trading time speeds up the clock in periods of high volatility and slows it down in periods of stability.

16) A sound trading strategy or portfolio construction would build these cold, hard facts into its foundations.

If we think we can identify every catalyst and control or predict outcomes, we are setting ourselves up for a fall.

17) In his 2004 book, The (Mis)Behaviour of Markets, Mandelbrot wrote:

“The precise market mechanism that links news to price, cause to effect, is mysterious and seems inconsistent. Threat of war: Dollar falls. Threat of war: Dollar rises. Which of the two will actually happen?”

18) “After the fact, it seems obvious; in hindsight, analysis can be reconstituted and is always brilliant. But both outcomes may seem equally likely.

So how can one base an investment strategy entirely on this one dubious principle: I can know more than anybody else?”

19) Mandelbrot’s theory offers a novel way of looking at the world and a more realistic picture of market risks.

As he said himself, “Beautiful, damn hard, increasingly useful. That’s fractals.”