Seabhaid Racing

An old trading adage states the following: markets can remain irrational longer than investors can remain solvent.

The slime mold, Dictyostelium discoideum, is a reddish orange mass of cells that can be found, among other places, coating rotting wood in damp sections of forests. Most of the time, the slime molds motions are barely perceptible, except when the weather conditions grow wetter and cooler when it suddenly "decides" to 'walk away". Indeed the slime mold spends much of its life as thousands of distinct single cell units, each moving separately from its other comrades. Under the right conditions, those myriad cells will coalesce into a single, larger organism, which then begins its leisurely crawl across the forest floor, consuming rotting leaves and wood as it moves about.

The slime mold aggregation is now recognized as a classic case study in bottom up behavior and self organization, similar in a sense to that occurring in stock markets.¹

“The commercial or political imperative to deliver relentlessly bullish opinion is extreme, even when insiders may actually feel more bearish. To make matters worse, it seems that most of us are hard wired to be gullible; to believe that authorities know what they are doing, and that a large consensus view should probably be adopted.” ²⁰

To Fischer Black, Myron Scholes and Robert Merton, price changes in financial markets were random. No one could predict any particular change, but over a long period of time, they assumed that the distribution of all such prices would mirror the pattern of random events like coin flips. The Black-Scholes formula explicitly states, " We will assume ideal conditions in the market for the stock and price of the option.. the stock price follows a random walk in continuous time".

Black-Scholes: makes a key assumption that the volatility of a security is a constant. Merton assumed that the volatility was so constant that prices would trade in continuous time, in other words without any jumps. Continuous time is merely an ideal state.

Eugene Fama, Scholes thesis advisor had written his thesis on the price movements of the DJIA stocks and discovered: for every stock there were many more days of extreme price movements than would occur in a normal distribution. In his words, if the population of price changes is strictly normal, on the average for any stock...an observation more than five standard deviations from the mean should be observed about once every 7,000 years. In fact such observations seem to occur about once every three to four years."

"The evangelical Merton showed disdain for the very possibility that investors could be anything but calculating automatons, and he blithely ignored the times when their emotions ran riot. Thus he took credit for the contribution that his theories made to "the portfolio-insurance products of 1980's" as if he were blind to the fact that ,when real people tried those products, portfolio insurance failed miserably"²

"The efficient market hypothesis is the most remarkable error in the history of economic theory" Lawrence Summers, former US Secretary Treasury

1. Why Stock Markets Crash: Critical Events in Complex Financial Systems, p 121. Didier Sornette.