November 3rd, 2011, 2:21 pm
The standard approach of the efficient markets concept dangerously underestimates the risks in the financial system. The long-term capital management crash of 1998 is one of many examples of the disastrous effects of market risk underestimation. In the 1970s and 1980s, this approach became ?...the guiding principle for many of the standard tools of modern finance . . . taught in business schools and shrink-wrapped into financial software packages... [It] is a house built on sand.? (Mandelbrot 2008). The efficient market theory promised ?expected? returns through clear, simple risk assessment and profile models based on risk aversion. In this model, option markets flourished and structured finance boomed (CDOs...). This model was adopted by financial markets, economics department and business schools who trained students on the basis of the modern portfolio theory (MPT), which attempts to maximise returns for a given amount of risk, or, alternatively, minimises risk for a given amount of return.Professor B. Mandelbrot (1924-2010) changed the way we view the world by introducing the fractal geometry of nature. He gave us a tool to describe different systems with common characteristics. Applied to finance it allows us to understand market instability as described by Professor H. Minsky (1919-1996). Wild prices, fat tails (that is, heavy-tailed market distributions that exhibit extreme skewness or kurtosis), and the long-term memory effect, led Mandelbrot to view the financial series as fractal series.Fractals are everywhere from cauliflowers to our blood vessels. Fractals have helped model the weather, measure online traffic, compress computer files, analyse seismic tremors and the distributions of galaxies. Mandelbrot hope was to build a stronger financial industry and an enhanced system of regulation. He developed a multifractal model with variable market time, exponential price distributions, and fractal generators. Some say that Mandelbrot described the financial system without explaining it, but no one can elucidate it. He was a wise observer and had a special way of scrutinizing objects and nature... thinking in a fractal way in finance is about observing, analysing and trading opportunities out off the markets anomalies! His hope was that people will accept the reality of risky markets and stop pretending otherwise. By identifying markets structures, what we essentially learn from B. Mandelbrot is that markets risks can be modelled so that people can avoid big losses - the question he left unanswered is how to do this in practice. A measure of risk should take into account long term price dependence or the tendency of bad news to come in flocks. Our focus shouldn't be on how to predict prices; but on how to foresee risks. Understanding the nature of the market allows us to use the clustering property of volatility as a tool to measure and forecast risk, ?opportunities are in small packages of time, large price changes tend to cluster and follow one another. If there was a large price change yesterday, then today is a risky day.? (Mandelbrot 2008,p.233). We may not be able to forecast direction, but with this understanding we can get out of the market at its clustery periods and reduce the chances of loss.