
Why didn’t people in finance pay attention to Benoit Mandelbrot? - cwan
http://blogs.reuters.com/justinfox/2010/10/18/why-didn’t-people-in-finance-pay-attention-to-benoit-mandelbrot/
======
jerf
Because what his theory boils down to is that you can't predict the market.
Pointing out that the market is describable by a self-similar fractal froth is
an interesting thought, but it basically means that if true, you can't predict
anything with any effectiveness. (Oh, you might be able to use that idea to
tune yourself up something that might work slightly better on a small time
scale, but as the market has sped up that small time scale has gotten awfully
small....)

Who wants to listen to a party pooper like that?

I've found a similar problem at work. It is my belief after studying the
problem for years, reading the work of many other of our smartest people
trying to solve it, and over a decade of experience, that estimating software
times are simply impossible except in the grossest of terms on any
significantly-sized project, especially as you get into the multi-month
estimates. Once you accept that, you can actually deal with it; Agile is in
some sense a response to this problem. But try convincing other people of that
fact. They'll tell you marketing needs some idea of when features go out, that
management needs some ability to plan on things, that sales needs some concept
of when to sell features. Well, _too bad!_ None of that makes it _possible_.
That is simply an extended explanation of why it sucks that we can't have
these accurate estimates. And yeah, I'll play the game because it's still
better than nothing.

I'm somewhat less sure that's true in the financial world. Shall we say, the
_evidence somewhat suggests_ that pervasive underestimation of risk can
_potentially_ have _slightly negative_ effects on the global economy.

~~~
joe_the_user
_Who wants to listen to a party pooper like that?_

Yes, yes, yes! The exact correct point.

Mandlebrot's finance papers, in published in the 1960's, refute Black and
Schole's Nobel Prize winning theories of the 1990's. Who wants to hear _that_?

Does Mandlebrot rate a Nobel himself? _Why of course not..._

Mandlebrot pointed the way to "another country", one which marketing can not
describe...

~~~
Natsu
Actually, I thought I read about someone who bought a certain position in the
market such that, if everything was priced correctly, they would lose a known
amount of money each day.

But every time a "black swan" sort of event occurs, they'd make big money. It
was on TV, so I don't have a citation handy, but I suppose that they could be
said to be making money off of the assumption that people can't correctly
price these things.

~~~
sharpn
That would be Taleb & Universa (the true extent of whose success has been
questioned, fwiw)

------
btilly
For those who don't understand the Black-Scholes references, here is a quick
explanation.

What Black and Scholes proved in their famous paper is that if you start with
a portfolio containing a certain fraction of money and stock, and rebalance
the portfolio constantly as the stock price moves according to certain rules,
then after a fixed amount of fluctuation in the stock price you will be left
with either pure stock or pure money, depending on the eventual price of the
stock. In short, this portfolio acts exactly like an option. And therefore the
price of an option should match the price of the portfolio. If it doesn't
match, then you can buy one and sell the other to get free money until they do
match.

This is fine, but in the real world we trade options based on a fixed period
of time, not a fixed amount of variation in the stock. The answer to this
which finance uses is to estimate the volatility of the stock. Given known
volatility, and a known time period, you can tell how much variation there is,
and then use the Black-Scholes model to price options.

Mandelbrot's critique of this is that volatility itself is not constant.
Therefore you can't really predict when the Black-Scholes portfolio will
expire. In particular the model systemically underestimates the likelihood of
extreme events. When this catches all of finance off guard, the result is
frequently some sort of crisis.

------
yummyfajitas
My suggestion why people didn't pay attention? He had no real theory. I've
read a couple of his books, here is the general formula: "Look, gaussian's
don't fit the market well. Aha, I've made a graph that looks visually
correct!"

Now, it's absolutely true that gaussian's don't fit the market well - they
only work sometimes. The thing is, everyone knows this, and tacks on
additional features to explain the other phenomena. For instance, one might
assume movements are normally distributed, except for short term spikes
followed by high volatility. A good risk manager will throw non-gaussian
volatility at a model during backtesting.

Mandelbrot's fractal story just didn't add much. The black scholes story has
some convincing theoretical background (it assumes an "evil" market out to get
you [1]). It misses things, but many of the things it misses can be added in,
in a more or less convincing way - e.g., I understand the black scholes part
of my model handles small movements, and the stochastic jumps handle the big
ones.

All Mandelbrot's model gives me is a graph that kind of looks right - it
doesn't give me any understanding.

[1] This is not the textbook description, but Bob Kohn convinced me this is
the best way to think of it.

~~~
wazoox
This would be fine, except that the short, rare, unpredictable spikes are
overall responsible for as much variation in value as the "predictable"
movements, which more or less makes all the exercise quite pointless.

~~~
yummyfajitas
How does the fact that a model has two features make understanding one of them
pointless?

If you are seeking a grand unified theory of everything, maybe it's pointless.
Black Scholes is just a model. If you are seeking to make money, Black Scholes
is one tool that can help you do that. And make no mistake - people do make
billions trading models which incorporate elements of Black Scholes.

~~~
wazoox
They make billions for some time, then all their profits are wiped out by some
"black swan". Fortunately, our governments are here to save the day...

------
T_S_
They didn't ignore him. Fat tails and jumps are just really hard to estimate
in finance. More interesting is that the unstated premise for these link-bait
titles (aka great headlines) is "If only they had listened to Mandelbrot, we
could have avoided all these problems."

It is nearly absurd on the face of it, but worth a comment. Like Louis
Bachelier's description of stochastic processes in 1900, mathematicians like
Mandelbrot have been inspired by financial time series to develop formal
_descriptions_ of the phenomena. Sometimes, this leads to a marginally deeper
understanding of the object of study.

Regardless, mathematicians and other scientists have little interest in
developing _prescriptions_ that would help control or reduce volatility. Most
observers seem to think that the amount of financial volatility is way too
high in comparison to the underlying economic realities. A few, like Fisher
Black, have had the opposite opinion and suggested that the prospects of the
underlying economy (including human capital) are actually hugely volatile.
Virtually all take the structure of markets as a given and assume they are
low-friction and generally structured well.

My own opinion is that volatility is mainly a function of information
starvation in the market. Just look at the poor quality of financial
accounting, auditing, and the cherished secrecy of large risky positions and
you can see possible areas to unlock information flow that would allow markets
to do a better job of tracking "true" value and ignoring chaff generated by
the act of trading.

~~~
eru
Or just look at banks.

If we did not have deposit insurance from the state, banks would probably be
much more pro-active in disclosing all their positions (including
liabilities), so that people still trust them. Some banks showed their
liabilities in the crisis, but this was way too late for people to pick them
apart, so it did not help with the trust.

~~~
T_S_
Excellent point. Instead we trust the regulators to make sure banks are a-ok.
We would do well to "crowdsource" bank regulation by requiring banks to stream
their positions to the public.

~~~
eru
Yes, and just don't offer deposit insurance, so that the public scrutiny has
some bite. Similar to how the `bond market vigilantes" the Economist is so
fond of keep the yield on government debt in line with the governments' fiscal
and monetary policies.

------
carsongross
I used to explain this with Upton Sinclare's great quote: "It is difficult to
get a man to understand something, when his salary depends upon his not
understanding it!"

Now, older and perhaps a bit more jaded, I would modify that to "Do not assume
that someone doesn't understand something. Assume that _he_ is assuming
someone _else_ doesn't understand that something."

Or, more succinctly, "There's a sucker born every minute."

~~~
jdc
Sinclare's quotation describes a self-actuated internal lack of awareness
while yours does not.

~~~
carsongross
Call it personal growth.

------
sabj
The most important take-away from Mandelbrot / fractals as it applies to
finance should be the realization that fractals can represent better ways of
presenting or simulating financial data than brownian motion / random walks /
Black-Scholes. As to why this hasn't been accepted more broadly - well, as the
article briefly mentions, there are powerful individual incentives for people
to continue to play along in the charade.

If this has not been proved EXTREMELY WELL by events in recent history, I
don't know when it would be - but whether from LTCM, or more recently seeing
so many CDS etc blow up, it is obvious that many "once in a million"
probability events exist than are considered in a proper normal distribution.

Mandelbrot was once asked whether he had any particularly successful
strategies for dealing with the market. He said, well, I don't discuss those
things - because if I was correct, everyone would follow my lead, and the
strategies would no longer work; and if I was wrong, people would discredit
the thinking behind it!

~~~
yummyfajitas
_...but whether from LTCM, or more recently seeing so many CDS etc blow
up,..._

I'm confused - how do CDS (did you mean CDOs) blowing up prove that a fractal
model of the market is better than the standard Black Scholes + assorted
tweaks model?

------
spolsky
One of them did -- Nassim "Black Swan" Taleb was great friends with
Mandelbrot.

~~~
charlief
Mandelbrot had qualitative and quantitative insight, but I am not sure Nassim
applied fractal brownian motion modeling/simulation to position himself for
tail events, but more simply had the qualitative understanding of where tail
event risks were greatly under-priced in the system at the time before anyone
else.

In terms of fractal brownian motion vs black-scholes-merton, it is a question
of practicality. It is really easy to hedge very complex portfolios with large
positions using BSM, especially after adding a few considerations to extreme
possibilities in volatility. Without BSM, we'd still be in the dark ages with
Option Seller(Writer) firms scalping buyers with option prices 10 times higher
inflation-adjusted than today. Mandelbrot doesn't offer a practical
alternative, and this is the part that people didn't listen to Mandelbrot on,
but that doesn't mean Mandelbrot is not awesome.

------
ANH
Recommended Mandlebrot read: 'Fractals and Scaling In Finance' from 1997.
[http://www.amazon.com/Fractals-Scaling-Finance-Benoit-
Mandel...](http://www.amazon.com/Fractals-Scaling-Finance-Benoit-
Mandelbrot/dp/0387983635)

------
cletus
Financial markets, from the perspective of mathematics, are quite interesting.

I wrote a paper that referenced some of Mandelbrot's work, namely that cotton
markets followed a Levy stable distribution:

<http://en.wikipedia.org/wiki/L%C3%A9vy_distribution>

It's an interesting distribution as it pops up in nature a lot too, such as
how birds find food.

Mandelbrot's work and the work of many others have shown the movement in
security prices resemble random walks. There is an awful lot of work that
shows markets are basically unpredictable.

Yet the reality is otherwise. People make an awful lot of money by predicting
markets, which shouldn't really be true to the degree that it is if movements
were random. There are trends like Mondays tend to be down days, Fridays tend
to be up days and so on.

Probably the biggest failing of financial modelling is the failure to
adequately factor in the fat tail. Incredibly unlikely events tend to be more
common than otherwise modelled. The collapse in the subprime mortgage market
is the most significant recent example of this.

Warren Buffett once characterized how many traders operate as picking up
pennies in front of an oncoming bulldozer. The vast majority of the time it's
safe but it's not 100% safe and the consequences are completely
disproportionate to the reward. It's a challenge to model that kind of
scenario.

Anyway, RIP Benoit Mandelbrot. You were a mathematical visionary.

------
drallison
Benoit wrote a scathing critique of modern economic theory and the assumptions
upon which it rests. Attacks on fundamental belief systems are generally
impolitic.

------
SkyMarshal
Here are a few pdf's of some articles in Wilmott Magazine touching on this
issue, and Mandelbrot's work in general:

<http://www.wilmott.com/detail.cfm?articleID=342>

From the _Emperor With No Clothes_ article:

 _And so why, we are obliged to ask, has one of the most important discoveries
in the history of economics failed to inspire a concerted effort to develop a
better theory? Perhaps it has to do with Mandelbrot himself and his position
vis à vis the kingmakers of economics who reserve the right to bestow
acknowledgment. Why has Mandelbrot not been recognized, say, with a Nobel
Prize in economics? Because he is considered an “outsider”—trained as a
mathematician and active in research that ranges well beyond economics alone?
Or has he failed to play by establishment rules and violated some unwritten
code of economist conduct?

Why, indeed, should Mandelbrot receive a Nobel prize in economics? The Nobel
is the ne plus ultra of global recognition; it carries considerable political
weight; it does not go unnoticed; the very fact of the award can stir things
up. In Mandelbrot’s case, everyone would be made aware that classical
economics – quite literally the emperor of our global economy – is without
clothes. Younger economists and students around the world would be motivated
to search for a better explanation of how economies work and why, and to
propose alternative theories validated by actual data and subject to empirical
scrutiny. Putting all of us, as real science always does, in the temporarily
uncomfortable position of not knowing in order that we may know._

------
ESchmidtSeesYou
I really wouldn't take an article seriously if it partially blames the '87
stock market crash on Black-Scholes (basic model for pricing European
options). That makes literally zero sense.

~~~
btilly
It makes literally zero sense unless you know something about that crash and
the financial markets of the time. In which case it makes perfect sense.

The Black-Scholes model provides a recipe for creating synthetic options that
will (under the assumption of known volatility) act just like real ones. Which
is convenient because you can create synthetic versions of options that people
want to have but which are not traded. Leading up to the '87 market crash,
lots and lots of these synthetic options were created. Then came the crash.

People can debate endlessly about why the crash started. But once it did,
there is no question that trading algorithms attempted to close out trades
that were necessary to maintain synthetic options. These large trades
attempted to execute in markets that had seized up, and made the market much,
much worse. The result contributed greatly to the crash, and caused the
synthetic options to fail to work as promised. (Besides, the Black-Scholes
algorithm guarantees that it acts like an option through a certain amount of
variation in the stock price, and not for a particular time period. The
volatility of the crash demonstrated the importance of this discrepancy.)

Now do you see how the Black-Scholes model contributed to that crash?

~~~
ESchmidtSeesYou
automatic trading based on Black-Scholes acerbated the crash != the Black
Scholes model contributed to the crash

Unrelatedly, is there anything wrong with, say, a mortgage-backed security
accurately priced according to a particular model, so long as the limitations
of the particular model's assumptions are properly understood? This applies to
any model in economics or finance. All are obviously just simplifications of
reality.

The technical assumptions of a mathematical model should not be blamed for the
actions of ignorant or reckless investors.

~~~
barrkel
You don't get a very big explosion with just a fuse, and no combustible
material. Without the combustible material, the fuse just fizzles out, no
great harm done.

It's a separate thing to blame a bad idea, versus blaming the people who
thought the bad idea was true. Language is ambiguous; trying to weasel one's
way out of "this idea is bad" by saying "the people who think this idea,
they're bad; it's not the idea itself", is IMO trying to rely on the
imprecision of casual language to refute an argument only for a single
formulation, but not in spirit. Ideas have no life of their own outside
people's heads. The same argument can be applied to say that there is no such
thing as a bad idea.

------
pshapiro
Found this quote interesting.

\---

Black-Scholes and the many financial risk models that have evolved from it
(including Felix’s friend the Gaussian copula) are all about volatility being
measurable and predictable. “When Black-Scholes came out, I said, ‘Well, it
won’t last,’” he told me in 2005. “‘I’ll come back when it’s gone.’”

------
borism
Oh, a lot of them did. Many of those can only be described as religious cult
followers - practitioners of Elliott Wave "Theory".

Some even went as far as accusing Mandelbrot of plagiarizing Elliott's work:
[http://www.math.utah.edu/vigre/reu/reports/harris_fall2005.p...](http://www.math.utah.edu/vigre/reu/reports/harris_fall2005.pdf)

~~~
ANH
I've read some of Mandelbrot's works on finance and I would never put him in
the same category as the "technicians". It's hocus pocus mumbo jumbo that I
don't think he would subscribe to (e.g. Elliot Wave's "5 up, 3 down"
principle).

~~~
SkyMarshal
Agreed. And finance was never the primary objective of Mandelbrot's
development of fractals anyway, just a side effect of varying degrees of
interest.

Elliot Wave appears to be an attempt to back fit a rather simplistic theory to
patterns in financial time series data. Fractals are so much more.

------
konad
Money talks so saying "it will never work" to people rolling in money won't
have any effect.

Had Benoit raked in the dough, it would be called "The Mandlebrot Strategy"
and everyone would be using it.

