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Hardbound

Making Sense Of Markets
How do markets really work? Benoit B Mandelbrot and Richard L Hudson look at popular theories to address the  question

Why are markets turbulent? I am a scientist, not a philosopher; so I can only hazard some suggestions. One possible source is the world outside the markets—what economists call exogenous effects. After I had, in the early 1960s, focused on scaling and long-term dependence, key traits of turbulence, I soon found innumerable other examples in many natural and economic phenomena; these phenomena, in turn, may impress a corresponding pattern on prices. For instance, I have found characteristic scaling patterns, from many small items to a few large ones, in the area and reserves of oil fields. The valuation of certain gold, uranium, and diamond mines in South Africa scales. Storms and earthquakes scale.

You can imagine a chain reaction. Weather affects harvests, and harvests affect prices. The distribution of natural resources around the globe—oil, gold, and other minerals—affects supply, hence affects prices. The same goes for business: The size of firms in an industry, from a mighty Microsoft to a legion of little software houses, also follows a scaling pattern. So, industry concentration affects profit, hence affects stock prices. Now, this is unsatisfactory for a rigorous analysis of cause and effect in economics. But if one must have a “story” to explain the data, then this is at least a plausible partial one. Scaling enters the system from the fundamentals of weather patterns, resource distributions, and industrial organization. Scaling finishes—and feeds back through the system again—in the marketplace.

Similarly, long-term dependence, another characteristic of turbulence, is found all round us. Think of a small country, like Sweden, where every big company does business, directly or indirectly, with every other one. Volvo does something that affects Saab—say, launches a new car model that steals market share. Saab comes back with a fancier car, making satellite-location services standard rather than an expensive option, and so Ericsson starts selling more Global Positioning System receivers. And so it spins on, throughout the Swedish economy—and spilling gradually into neighboring Finland and Nokia, to Norway and Statoil, and as far around the globe in ever-diminishing ripples as we can measure it. Now imagine the same phenomenon in a large country, like the United States. How much more numerous, more complex, more significant are the economic repercussions of any one company’s actions? Imagine, finally, the world economy: a chamber of mirrors. Each company relays, distorts, and attenuates the economic signals as they flash around the globe. The signals fade in time. But it can take months, years, or decades for a signal to become so weak and remote as to be unremarkable. Such is long-term dependence in an economy: Every event, no matter how remote or long ago, echoes across all other events.

No question, such speculation is very tentative, and I prefer to avoid it. To drive a car, you do not need to know how it goes; similarly, to invest in markets, you do not need to know why they behave the way they do. Compared to other disciplines, economics tends to let its theory gallop well ahead of its evidence. I prefer to keep theory under control and stick to the data I have and the mathematical tools I have devised. They permit me to describe the market in objective and mathematical terms as turbulent. Until the study of finance advances, for the how and why we will each have to look to our own imaginations.

This is an extract from Benoit B Mandelbrot and Richard L Hudson's The (Mis)behavior of Markets published by Basic Books

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