The Investment U E-Letter: Issue # 397
Thursday, December 23, 2004 Everything You Learned About Investing Is Wrong
By Dr. Steve Sjuggerud, President, Investment U "Alas, the [old "normal"] theory is elegant but flawed, as anyone who lived through the booms and busts of the 1990s can now see." ~ Benoit Mandelbrot The 20th century was an off-the-charts calamitous era in stock markets… "Or perhaps our assumptions were wrong…" says Benoit Mandelbrot, who invented an entire field of mathematics. Mandelbrot says the entire field of investment analysis is "founded on a few shaky myths." Basically, everything you've learned about investments is completely wrong, as it's been built on faulty assumptions. Mandelbrot's findings are scandalous… He rakes Wall Street with this idea from his new book, The (Mis)Behavior of Markets. Specifically, Mandelbrot says that the accepted wisdom substantially underestimates the potential for loss. In plain English, financial markets don't follow a "normal" pattern. A few examples… - If the market followed a "normal" pattern based on statistics over the last century, "there should be 58 days when the Dow moved more than 3.4%." Instead, Mandelbrot found "there were 1,001."
- Similarly, the "normal" assumption of Wall Street suggests "six days of index swings beyond 4.5%; in fact there were 366…"
- More from Mandelbrot: "Index swings of more than 7% should come once every 300,000 years; in fact the 20th century saw 48 such days."
So Wall Street's basic assumption, that everything should fit as "normal," is wrong. Where to from here? Let's take a look… Two Findings That Rock the Establishment "Normal" is what the academics want. It's what all the work they've done is based on. For example, the "normal" assumption by academics is that "yesterday's price change does not influence today's… each price change is independent from the last." Another theory based on "normal" is the efficient market theory… that markets won't boom or bust because markets are efficient… they are correctly priced at basically every moment. Hogwash, says Mandelbrot. The accepted wisdom says that prices move randomly. Mandelbrot says price changes are not random… "Today, in fact, does influence tomorrow…" "If prices take a big leap up or down now, there is a measurably greater likelihood that they will move just as violently the next day… Whatever the explanation, we can confirm the phenomenon exists - and it contradicts the [normal] model." What We Need to Know Early on in the book (page 20), Mandelbrot lets us in on what we need to know about how markets differ from popular perception: - MARKETS ARE RISKY. Much riskier than most imagine
- TROUBLE RUNS IN STREAKS. Contrary to the accepted wisdom that stocks move randomly, big moves are often followed by big moves.
- MARKETS HAVE A PERSONALITY. Markets are driven by the actions of people, not by fundamentals, wars, etc.
- MARKETS MISLEAD. Investors love to find patterns and statistical mirages where none exist.
You might find Mandelbrot's book a bit technical, or you might find these points a bit obvious from your own experience. But this 80-year-old founder of fractal geometry really sticks it to Wall Street in this book. I love it. We'll all be winners from his efforts, as his influence will likely cause Wall Street to better estimate the risk you take whenever you buy a stock or shuffle your portfolio. If you're interested in these things, read Mandelbrot's book, The (Mis)Behavior of Markets. If you're not so interested, at least realize that the financial establishment has made a big mistake in estimating the risk in your portfolio… You can lose more money than Wall Street previously thought… or wanted to admit. Thank you, Benoit Mandelbrot, for sticking it to the establishment. We'll all be better off for your efforts. Good investing, Steve Back to Archive | 
