Every investor, and I suppose generally every earthling, should understand the gist of “Chaos Theory” You can learn more than you need to know at Wikipedia. Chaos Theory
They main point is that even if future outcomes depend completely on initial conditions, deterministic, there is no way to be sure that the past and present inputs will predict future results. The hard part to wrap you head around is that deterministic systems, those that can be shown to have strong cause and effect relationships, can be chaotic. It is colloquially known as “The Butterfly Effect”
The nature of a chaotic system is results, while clearly and completely connected to initial conditions, are unpredictable. Most of reality is composed of non-linear systems and they cannot be described with linear approximations. Edward Lorenz’s observation sums it up:
“Chaos: When the present determines the future, but the approximate present does not approximately determine the future.”
Rounding off initial data at the fifth decimal is quite enough to create chaotic output in complex systems.
No one knows the complete and accurate present state of the stock market or the economy or even their health. We have approximations and rules of thumb, and intuition, but that is not sufficient precision. That means we cannot approximately determine the future.
What we can do is understand that while we don’t know the future, we can know that chaotic systems have “attractors.” We can deal with these attractors (tendencies) but we must be more ecumenical. We will see many unexpected, and foreign to our belief, results as we follow our chaotic path and we must accept them and learn from them.
If we listen to N.N. Taleb, we can find situations that help us make money when unexpected ends are encountered. Some chaotic results are helpful and we should understand that.
You could also learn something about mathematician Benoit Mandelbrot’s approach to the stock market. It is well off the normal playing field for the theorists on Wall Street, so perhaps that alone can recommend it. His book, “The (Mis)Behavior of Markets” is worth some time. Hint: The market is far more volatile than you think.
MoneyOracle in the UK has pointed out,
“Mandelbrot’s groundbreaking insights into the operations of the stock market could have been used to avert the 2008 crash – had those insights only been heeded.”
Heeding and using information are important parts of moving forward successfully. There is considerable evidence that the conventional way of understanding the stock market is in fact, incomplete. Possibly wrong. People should know how that is.
As an investor, always be on the lookout for oppositional positions. They complete your knowledge. You know why your thing is true and why the other is not. Knowing that a thing is true without comparison is dangerous.
Ignorance can be cured, but received wisdom and preconceived ideas are forever.
Don Shaughnessy is a retired partner in an international public accounting firm and is now with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.