Investing in the Ocean: Complexity and the Random Walk Theory

Alexey Sokolin

Investing in the Ocean: Complexity and the Random Walk Theory

Volatility: An Introduction

You decide to invest in a company that builds solar panels. They buy raw materials from China and ship them to Canada, where a team of well-educated environmentally-aware college graduates manufactures them for export to the rest of the world. The company is a media darling and looks like it has an innovative, successful business model—helped, not least, by government subsidies in the wake of Kyoto and Copenhagen. Jim Cramer loves it.

Suddenly, Greece announces it may default on its sovereign debt. You are not worried, because the company seems unrelated to Greece, and one should not have affect the other. But others do worry, and concerns about a credit crisis sweep across Europe. Wall Street analysts adjust down their projection for our solar company and it becomes a sell overnight—because if the Europeans don’t have the money to invest in green energy, it’s a sure thing that nobody else will, either.

Your stock pick is down 40% and, finally panicking yourself, you sell all of it. Of course, the next day a deal is reached in Germany and the stock rebounds. But it’s too late for you.

Layered Complexity & The Random Walk Theory

This is an all too common story, with different permutations of unexpected shocks and negative surprises. The professionals say that such moves can be predicted, but some think there is a simply overwhelming number of factors—far too many for anybody to keep track of. Events like your company’s crash might as well be random. In his famed book, A Random Walk Down Wall Street, Princeton economist Burton Malkiel argues that they actually are random (at least as far as everyday investors are concerned) and that stock prices, as a result, cannot be predicted in the short term. Although it was first published in 1973, this book’s thesis still stands up to scrutiny today. In 2009, noted finance professor Kenneth French showed that investors spend $100 billion trying to beat the market every year—expensive competition that makes it more difficult for those same investors to win. The lesson? Stop trying to time the stock market, turn off CNBC and Bloomberg, and buy a diversified portfolio of Exchange Traded Funds (ETFs). You’ll save money, allocate your time to more productive uses, and reduce the likelihood of portfolio-shattering losses.

Such advice is nowhere near as exciting as following an explosive stock story. We all want to find the next Apple or Google, or predict the next Lehman Brothers bankruptcy. But Malkiel and other economists have shown that even most professional mutual fund managers perform worse than their benchmark . These are people who focus all day long on stock selection. Hobbyists—with day jobs as lawyers, consultants, or managers—should be wary.

The market may not be truly random, but it certainly looks that way. It is highly complex, and without the quant PhDs and supercomputers of elite hedge funds, years of experience and secret sauce of Warren Buffet’s stock picking, it is practically impossible to divine its next move. In many ways, the market is like an ocean, or a mathematical fractal. On the surface there are small regular waves, which get subsumed by larger waves. Ships leave wakes that cut into the familiar patterns. Winds from different continents create cross-directional movement. Earthquakes generate tsunamis. The moon pulls the tides. And climate change disrupts all expectations completely.

The stock market is similarly confusing. There are different institutional players—like mutual funds, hedge funds, endowments and pension funds, and Wall Street firms—all competing to outperform each other. Some use complex math to trade every nanosecond, while others arbitrage large trades that enter the market. Some firms bet on individual companies and others on the economy as a whole. In a market as liquid as the NYSE, there is a myriad of strategies and investment philosophies—technical, fundamental, quantitative, macroeconomic. And the list goes on.

It is not surprising investing can feel like being on a sailboat in a raging storm. Riding a wave up is thrilling, but requires abnormal luck. There is a place for taking chances in a balanced portfolio, but it is a limited one and the associated risk must be diligently monitored and contained. When investing for the future, getting caught up in the tides of the market can be a fatal mistake. This is why we are building a product that thinks holistically about how assets and holdings fit together and help build real financial plans.

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