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Article-Dangerous Market

 
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arthur
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PostPosted: Sat Sep 04, 2004 8:40 am    Post subject: Article-Dangerous Market Reply with quote

08/24/04 - Posted from the Daily Record newsroom
Mathematician argues markets more dangerous than investors know
By Warren Boroson, Daily Record

A key message of Benoit Mandelbrot's book "The (Mis)behavior of Markets" (Basic Books, 2004, co-written by Richard L. Hudson), is that investment markets in general and the stock market in particular are riskier and more dangerous than people know.

Investors should therefore be more cautious.

Indeed, the last sentence in his book is: "Like the weather, markets are turbulent. We must learn to recognize that, and better cope."

His argument runs counter to the popular view that stocks long-term are not just the most profitable investment, but the safest - a view given prominence several years back in the best-selling book "Stocks for the Long Run" by Jeremy Siegel.

Mandelbrot, 80, is a mathematician at Yale and the creator of "fractal" geometry, which focuses on the regularities in various irregular systems, from wind tunnels to coastlines. If mathematicians received Nobel Prizes, he probably would be first in line.

His book is difficult. Sometimes I had trouble understanding him, especially when he is writing about fractals and not about investing, which is much too often.

But he is not afraid to argue that the emperor has no clothes, that most of the leading financial theories accepted today are - if not exactly hogwash - badly flawed.

His arguments are persuasive, and sometimes, he expresses himself in memorable prose.

The stock market, he says, is more dangerous than people know because it's not stable and peaceful, but turbulent. (Think of the bear markets of 1987, 1997 and 2000.)

I remember telling a gentleman of 70, back in 2000, that he should cut back on his exposure to stocks. "I'm in for the long run," he told me confidently.

No, I never went back and told him, "I told you so," because a few years later, he told me, "You were right."

Think of all the investors who lost their shirts, and their early, comfortable retirements, when the Internet bubble burst because they were not sufficiently aware, as Mandelbrot is, of how treacherous the stock market is.

Too many people, Mandelbrot argues, think that the "bell curve" is found everywhere in nature, that most things congregate in the middle, and that the relatively few exceptions peter out on the left and the right. (Hence the shape of a bell.)

Nature not only abhors a vacuum; nature loves mediocrity. There are a few people with high IQs, a few people with low IQs, then there are the rest of us.

But the bell curve, Mandelbrot argues, doesn't apply to the stock market, the cotton market or to markets in general.

"The seemingly improbable happens all the time in financial markets," he writes.

Citing the drops in the market in the latest 1990s, he calculates that the odds against this were less than one in 10 to the 50th power. Yet abrupt drops and sharp spikes occur in the market year after year, proving that the system is not calm, but turbulent.

"Extreme price swings are the norm in financial markets - not aberrations that can be ignored," he writes.

Brokers may urge people to keep 45 percent of their portfolios in stocks, he notes. But many people are dubious. The Japanese keep 53 percent of their financial assets in cash and barely 8 percent in stocks. Europeans keep 28 percent in cash, 13 percent in stocks.

Another fundamental belief of academics that he attacks is the efficient market hypothesis - the absurd notion that (a) all information about stocks is out there and (b) everybody interprets the information the same way, therefore (c) stock prices are always reasonable.

Curiously, this absurd view was invented by a former student of Mandelbrot: Eugene Fama.

Stocks follow a "random walk"? There's no relationship between what happens to a stock Monday and what happens Tuesday?

Actually, Mandelbrot argues, drops and rallies tend to congregate together. There really is momentum.

As for a central tenet of Modern Portfolio Theory - that a group of risky investments in one portfolio can be safe because they are not correlated and they won't all sink together - well, they may, he argues.

I remember years ago when the manager of a mutual fund, Fidelity Asset Manager, owned a portfolio of risky investments, and for a while, they did splendidly.

Then the whole thing blew up. Because when investors in Newark get nervous, so do investors in Neufchatel.

So, should all of us cut back on our investments in the stock market?

Older people probably should. I meet a lot of older people - "older" meaning five years older than you are, dear reader - who have too much money in the stock market.

Why? I ask them. "I know more now," they tell me. And "I'm not going to panic."

You know what? I don't believe them. They don't know more, and yes, they are going to panic.

Still, most investors probably should keep their current exposure to the stock market, providing that it's a moderate exposure.

After all, people have argued that because of Social Security and our pensions, we have more exposure to fixed-income investments than we think.

Instead of our being 50 percent in stocks and 50 percent in bonds, we may be 40 percent in stocks and 60 percent in bonds - so we should buy more stocks.

But maybe we shouldn't -because, as Mandelbrot argues, the stock market is so turbulent.
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