The Edge of Chaos : Financial Booms, Bubbles, Crashes and Chaos

Rating:
Summary: Summary of the book
Review: Introduction

The objectives of the book are:  To study in detail the stock market crashes, to discover what went wrong and to learn from these past traumatic episodes; and  To identify and explain the underlying structure of the financial market behavior.

Chaos is Discovered Newtonian vs. Chaos For the last 300 years, our thoughts have been profoundly influenced by the Newtonian theory, which, as we know, rests on assumption of a linear system. This theory is best applied to system with two objects interacting with each other. When used to elucidate the system with three objects or more, Newtonian theory collapses.

Chaos theory, which is based on complex and non-linear system, is a relatively new discipline (circa 30 years). Its use in social science and field of physics have gained wide acceptance. The author attempts to apply the theory to the financial market.

Chaos Rules

Chaos describes unpredictable behavior that is governed by rules. Ian Stewart in his book, "Does God Play Dice?" gives the following definition: "Chaos is lawless behavior governed entirely by law".

Chaos in Financial Market

The author comment regarding the stock market behaviors using the chaos theory is as follows:  Financial market is inherently unstable and dynamic system, and the mood of the majority of its player can flip almost instantaneously from one state to another. Hence financial market resembles a chaotic system. An orderly phase may dissolve into chaos & then tip back to a more ordered state.  Stock markets are holistic that sometimes their collective behaviors will be different from that of their component unit (i.e. individuals & investors).

Chaos Theory in Actions After noting the similarities between financial markets behavior and chaos theory, the author studied several important financial crises over the last 300 years to see whether there was any underlying structure beneath the crashes. She discovered that many speculative bubbles shared a cluster of common features. \ The author does not try to predict when the crash will happen. Instead, she seeks to uncover what is the underlying structure of financial market and how investor can profit from it by assessing in which phase he is at a particular time.

The author studied the following crashes and described the sequence of events using the ten phase structure: 1. Bubbles of 1720  Mississippi Madness  South Sea Fiasco 2. Modern Bubbles  Great Crash 1929  Global Crash 1987  Japanese Bubble  Bonds Bubble

So what if we know the history and chaos theory?

How To Be Prepared? Compiling a checklist based on the structure of crash scenario (ten-phase structure) has the following purposes:

 It is a systematic way of dealing with the situation. It provides an orderly framework to analyze the signals and prepare oneself for any occurrence of the crash; and

 It helps the investors to judge more clearly how far along the route of chaos scenario has progressed.

(The checklist is elaborated in the textbook).

In addition to the checklist, there is also a need to look out for other cluster of symptoms or occurrence of other events (such as emergence of new financial tools, collapse of big corporations etc) to confirm the findings from the checklist.

What to do with the checklist? To avoid any avalanche of selling, one must be able to identify at least the first 3-5 phases and clear your position at phase 5 or 6 (i.e. when gullible public joins in or when doubt starts to form).

However, if one misses the signal and fails to sell off by phase 6, it is still not too late to do so as long as it is done before the markets reach the bottom. This will allow one to cash out and reinvest when the markets hit the bottom.

What if u misses all the phases? - As the chaos theory shows, the market will turn around eventually. However, the issue is how long will it take? No one knows.

Timing the Crash - Is it possible? Whilst it may not be too difficult to identify the signals of an impending crash (based on the phases in the structure of crashes), one can never accurately predict the timing of occurrence. Time is the most untrustworthy and unpredictable element. As shown in the charts, the points might get squeezed together or pulled part -- this is a common feature of a chaotic system.

Since predicting the exact timing of crashes is highly unreliable, in order to avoid being caught off guard, one has to closely watch for any trigger event that may unleash a selling cascade. Another strategy is to give up the hope of catching the extreme peak and bottom and be contended as long as you buy near the bottom and sell near the top.

Conclusion

Chaos theory has taught investors how to preserve their capitals from the disaster of a crash. The 3 main points to bear in mind are as follows:

 Need to recognize any unintentional actions of the financial authorities which may create a classic chaos conditions and prepare own course of actions;

 Even the most sophisticated and cautious long term investors can become irrational and act in tandem with the speculators; and

 Understand that falling bond prices with rising interest rate may result from the collapse of a financial pump instead of a reflection of the fundamental outlook of the economy.

One of the most important events to watch is the action by the presiding authorities which may trigger a financial pump and set the phase transition in motion. When it happens, one should know how to react.

In conclusion, as a Fund Manager, one should

 Be fully aware of what is happening in the financial, political and economic sectors around the world. One of them could be the trigger event.  Be able to identify at which phase the financial market is in and predict the transition and the edge of chaos.  Be able to clear his position and not to be influenced by the herd behavior if he concludes that the market at peak and near the point of collapse. This is a tough discipline to follow especially if he has a strict mandate and the clients' expectations increase during the boom.

Rating:
Summary: Summary of the book
Review: Introduction

The objectives of the book are:  To study in detail the stock market crashes, to discover what went wrong and to learn from these past traumatic episodes; and  To identify and explain the underlying structure of the financial market behavior.

Chaos is Discovered Newtonian vs. Chaos For the last 300 years, our thoughts have been profoundly influenced by the Newtonian theory, which, as we know, rests on assumption of a linear system. This theory is best applied to system with two objects interacting with each other. When used to elucidate the system with three objects or more, Newtonian theory collapses.

Chaos theory, which is based on complex and non-linear system, is a relatively new discipline (circa 30 years). Its use in social science and field of physics have gained wide acceptance. The author attempts to apply the theory to the financial market.

Chaos Rules

Chaos describes unpredictable behavior that is governed by rules. Ian Stewart in his book, "Does God Play Dice?" gives the following definition: "Chaos is lawless behavior governed entirely by law".

Chaos in Financial Market

The author comment regarding the stock market behaviors using the chaos theory is as follows:  Financial market is inherently unstable and dynamic system, and the mood of the majority of its player can flip almost instantaneously from one state to another. Hence financial market resembles a chaotic system. An orderly phase may dissolve into chaos & then tip back to a more ordered state.  Stock markets are holistic that sometimes their collective behaviors will be different from that of their component unit (i.e. individuals & investors).

Chaos Theory in Actions After noting the similarities between financial markets behavior and chaos theory, the author studied several important financial crises over the last 300 years to see whether there was any underlying structure beneath the crashes. She discovered that many speculative bubbles shared a cluster of common features. \ The author does not try to predict when the crash will happen. Instead, she seeks to uncover what is the underlying structure of financial market and how investor can profit from it by assessing in which phase he is at a particular time.

The author studied the following crashes and described the sequence of events using the ten phase structure: 1. Bubbles of 1720  Mississippi Madness  South Sea Fiasco 2. Modern Bubbles  Great Crash 1929  Global Crash 1987  Japanese Bubble  Bonds Bubble

So what if we know the history and chaos theory?

How To Be Prepared? Compiling a checklist based on the structure of crash scenario (ten-phase structure) has the following purposes:

 It is a systematic way of dealing with the situation. It provides an orderly framework to analyze the signals and prepare oneself for any occurrence of the crash; and

 It helps the investors to judge more clearly how far along the route of chaos scenario has progressed.

(The checklist is elaborated in the textbook).

In addition to the checklist, there is also a need to look out for other cluster of symptoms or occurrence of other events (such as emergence of new financial tools, collapse of big corporations etc) to confirm the findings from the checklist.

What to do with the checklist? To avoid any avalanche of selling, one must be able to identify at least the first 3-5 phases and clear your position at phase 5 or 6 (i.e. when gullible public joins in or when doubt starts to form).

However, if one misses the signal and fails to sell off by phase 6, it is still not too late to do so as long as it is done before the markets reach the bottom. This will allow one to cash out and reinvest when the markets hit the bottom.

What if u misses all the phases? - As the chaos theory shows, the market will turn around eventually. However, the issue is how long will it take? No one knows.

Timing the Crash - Is it possible? Whilst it may not be too difficult to identify the signals of an impending crash (based on the phases in the structure of crashes), one can never accurately predict the timing of occurrence. Time is the most untrustworthy and unpredictable element. As shown in the charts, the points might get squeezed together or pulled part -- this is a common feature of a chaotic system.

Since predicting the exact timing of crashes is highly unreliable, in order to avoid being caught off guard, one has to closely watch for any trigger event that may unleash a selling cascade. Another strategy is to give up the hope of catching the extreme peak and bottom and be contended as long as you buy near the bottom and sell near the top.

Conclusion

Chaos theory has taught investors how to preserve their capitals from the disaster of a crash. The 3 main points to bear in mind are as follows:

 Need to recognize any unintentional actions of the financial authorities which may create a classic chaos conditions and prepare own course of actions;

 Even the most sophisticated and cautious long term investors can become irrational and act in tandem with the speculators; and

 Understand that falling bond prices with rising interest rate may result from the collapse of a financial pump instead of a reflection of the fundamental outlook of the economy.

One of the most important events to watch is the action by the presiding authorities which may trigger a financial pump and set the phase transition in motion. When it happens, one should know how to react.

In conclusion, as a Fund Manager, one should

 Be fully aware of what is happening in the financial, political and economic sectors around the world. One of them could be the trigger event.  Be able to identify at which phase the financial market is in and predict the transition and the edge of chaos.  Be able to clear his position and not to be influenced by the herd behavior if he concludes that the market at peak and near the point of collapse. This is a tough discipline to follow especially if he has a strict mandate and the clients' expectations increase during the boom.