Rogue waves and the stock market

11Jul06

One of the lessons of Michael Mauboussin’s book “More Than You Know” is that it is indeed useful for investors to look beyond finance and economics to other fields including the physical sciences to help gain some insight into how the world actually works.

An article by William J. Broad on scientific research into so-called “rogue waves” in the New York Times reminded us in many ways of the stock market. Rogue waves are giant waves found in the deep ocean that are distinct from seismic caused tsunamis. Rogue waves can damage or sink even the most seaworthy of vessels and do so on a regular basis. Think of the book and movie, “The Perfect Storm.”

One of the interesting points was that not until recently was there a clear consensus on the actual existence of rogue waves. Recent events have allowed for the measurement of actual rogue waves versus anecdotal evidence. Academic research has shown that the stock market experiences “crashes” far more often than that dictated by financial theory. Standard finance theory characterizes equity market returns as being lognormal. However actual returns differ markedly from this standard with far more large price moves than predicted. The returns demonstrate excess kurtosis or “fat tails.” It is in these fat tails where we see destructive market events.*

Scientists have two separate hypotheses on how rogue waves can form. The first is the steady accumulation of smaller waves that synchronize into a much larger than normal rogue wave. The second is somewhat more predictable in that in certain areas with steady currents strong winds and waves can create a rogue wave. This is not altogether different than the stock market.

Sometimes a stock market crash in retrospect looks like an accumulation of many small factors that in the end add up to a much larger than expected move. Think October 1987. On the other hand some areas and markets seem to be more prone to crashes than others. Earlier this year the Indian stock market dropped 10% in a day. Most would concede that many emerging markets are more prone to these rogue events.

Scientists are trying to expand their understanding of rogue waves in the hope of being better able to predict their occurrence. However to some degree these rogue waves will remain in part unpredictable. Shipbuilders are taking to heart this recent research and are looking to add elements to their ships to help withstand the waves, although there is clearly no absolute protection against these waves.

Just as anyone who ventures into deep sea waters takes the risk of rogue waves, so do investors who choose to invest in risky assets. Once one ventures beyond the safety and security of Treasury bills inherent risks remain. While regrettable this is in fact the only way investors can generate real returns in excess of inflation and taxes. Clearly some asset classes and markets are more prone to crashes and panics. However no market is immune. Like the sea there is no absolute protection against a crash. One can try and make one’s portfolio more “seaworthy” but that is by no means a guarantee of safety.

Rogue waves are an interesting analogy to the stock market. To a large degree they are unpredictable. Therefore take with a grain of salt the drumbeat of predictions of market pundits who claim to see the next “market wave” around the corner. Some markets may be more prone to events, but that does not mean they should be absolutely avoided. Investors can do what they can to make their portfolios more secure, but they must remember that there is no safe haven once you venture into the world’s markets.

*Chapter 25 of Mauboussin’s book is a nice discussion of “Fat Tails and Investing.”

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