<<the misbehavior of markets>> by Mandelbrot and Hudson

5 rules of market behaviors:

1) Market are risky; 2) Trouble runs in streaks; 3) Markets have a personality; 4) Markets mislead. Patterns are the fool’s gold of financial markets.  The power of chance suffices to create spurious patterns and pseudo-cycles that, for all the world, appear predictable and bankable.  They would fool any professional “chartist.” Likewise, bubbles and crashes are inherent to markets.  They are the inevitable consequence of the human need to find patterns in the patternless.  5) Market time is relative.  “Trading time” is quite distinct from the linear “clock time”.  This trading time speeds up the clock in periods of high volatility, and slows it down in periods of stability. 

10 Heresies of Finance

1. Markets are turbulent.
2. Markets are very, very risky – more risky than the standard theories imagine.   It’s hard to predict, harder to protect against, hardest of all to engineer and profit from.  The Wall Street mantra is asset allocation.  It’s far more important than the specific stocks or bonds you pick.  25% cash, 30% bonds, and 45% stocks.
3. Market “timing” matters greatly.   Big gains and losses concentrate into small packages of time.  From 1986 to 2003, USD descent against JPY.  Nearly half that decline occurred on just 10 out of those 4695 trading days.  46% of the damage to USD investors happened on 0.21% of the days.  In the 1980’s SP500, 40% of positive returns came during 10 days – about 0.5% of the time.
4. Prices often leap, not glide.  That adds to the risk.  The result is a far-wilder distribution of price changes: not just price movements, but price dislocations.
5. In markets, time is flexible. 
6. Markets in all places and ages work alike.
7. Markets are inherently uncertain, and bubbles are inevitable.  Parable: Land of Ten Thousand Lakes.  Explorers = investors, fogs = the limits of our knowledge, lakes = prices of 10,000 different securities. 
8. Markets are deceptive.  Chance alone can produce deceptive convincing patterns.
9. Forecasting prices may be perilous, but you can estimate the odds of future volatility.  Random Walk model’s first claim is the so-called martingale condition: your best guess of tomorrow’s price is today’s price.  It helps in an intuitive way to explain why we so often guess the market wrong.  Markets can exhibit dependence without correlation.  The key to this paradox lies in the distinction between the size and the direction of price changes.  A 10% fall yesterday may well increase the odds of another 10% move today – but provide no advance way of telling whether it will be up or down.  Large price changes tend to be followed by more large changes, positive or negative.  Small changes tend to be followed by more small changes.  Volatility clusters.
10. In financial markets, the idea of “value” has limited value.  How, you ask, does one survive in such an existentialist world, a world without absolutes?  People do it rather well all the time.  The prime mover in a financial market is not value or price, but price differences; not averaging, but arbitraging.  People arbitrage between places and times.  Between places: driving used convertible to California to sell dear.  Between times: Scalping. 

Olsen “We literally know nothing about how economics works.”

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