New research in the US, just published in the journal “Chaos”, has uncovered why investing in the markets can be a rollercoaster ride.
A team of researchers at the American Institute of Physics built a model incorporating some of the latest understanding of chaos theory to simulate asset prices in what they call “bifurcation conditions” – market turning points.
Most theories on rational markets assume that investors and speculators are armed with the same tools, information and habits, but this new model attempted to take into account the reality that we’re all different – even professional investors will have different approaches to valuing stocks that influence at what points they buy or sell.
The researchers focused in particular on chartists, those who base their decisions more on the direction stocks are moving to guide investment decisions, and fundamentalists, who are more concerned about the intrinsic value of a stock.
They found that the interaction of the two styles of investing could result in small market movements triggering surprisingly strong reactions – creating what has been described as “a virtual financial butterfly effect”.
This paper follows a long and noble academic tradition of making common sense barely intelligible. (It concludes: “The trading behaviour of chartists and fundamentalists implies that asset prices are driven by a one-dimensional piecewise linear map with two discontinuities.” I rest my case.)
It recognises that its comparatively simple approach of concentrating on just two different types of investment style is basic and yet produces results that are hard to comprehend in all their detail. And it tells us that if we want to really understand markets it will be a step-by-step research journey – no doubt one that will keep many academics gainfully employed for years to come.
Meanwhile, those of us charged with protecting other people’s wealth who want something more practical to go on can draw two things from this paper – a conclusion and a reminder. The conclusion is that it is going to be a long, long time before we fully understand markets and can predict accurately what they will do next (at which point, assume that the rules will all change anyway). The reminder is that markets are not rational, which is actually something to celebrate. Because this is not just where the risk lies but also the opportunity.
As the chaos paper underlines, investors can over-react. They get swept up in the emotion of rising markets, falling for the latest new paradigm that is supposed to re-write the rules of investing, only to over-react when reality strikes home and markets correct. They then panic when markets fall – turning a correction into a crisis.
We don’t need weighty academic research to understand that. The secret of successful investing is actually quite simple at its core – keep your head when all around you are losing theirs. Or as Warren Buffett said: “Be greedy when others are fearful and fearful when others are greedy.”
PS: And for the record, at JH&P we have an agnostic view of investment styles and have no particular bias – we are happy to consider the merits of each approach.
Posted 1 June 2018
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