Risk, uncertainty to ring in 2012

By Andrew SHENG

For most investors, 2011 must be an annus horribilis — a year of losses for most except the short-sellers. After a year of losses, you can almost believe anything. According to the Mayan calendar that ends 5,125 years on Dec. 21, 2012, cataclysmic events will occur one year from now. Chinese astrologers believe that the Year of the Water Dragon is a year of fundamental change. If you believe Euro-skeptics, the Euro will collapse next year and a new order will emerge.

Christmas is a time to slow down for reflection. It is a time to get away from daily BlackBerry emails to a world where life seems timeless. Every year, my wife and I go backpacking somewhere East of Bali. Indonesia is an archipelago of 17,500 islands, exotic cultures and the world’s fourth-most populous country. Here, we travel by local buses, shop in the rural markets, speak only Malay and just wander where our spirits take us.

Indonesia is one country where the BlackBerry is still growing in usage, although amongst the more affluent, the iPhone4 is in. Inflation seems to have set in everywhere, but even in remote provinces, hot money has poured into gold and coal mines and building construction is ubiquitous. Indonesia is clearly on the move. My scenarios for the next year are always defined by what books I bring along to read and reflect on questions I missed this last 12 months.

Why did the financial markets behave so dismally in 2011?

For this, I delved into Benoit Mandelbrot and Richard Hudson’s 2008 book on “The Misbehavior of Markets — A Fractal View of Risk, Ruin and Reward.” The late French mathematician Mandelbrot worked all his life in IBM and invented “fractal geometry,” defined as rough or fragmentary geometric shapes that can evolve into great complexity.

In the late 1960s, Mandelbrot started applying his mathematics to the study of markets. The founder of the widely used Efficient Market Hypothesis, Eugene Fama, was in fact a doctoral student of Mandelbrot. He argued that stock price movements are unpredictable and follow a random walk. His hypothesis assumes that prices are independent and are normally distributed, namely, they follow the Bell curve. In contrast, Mandelbrot, who studied the cotton market, argued that market prices are not independent of each other. Their evolution goes through periods of quiet and then extreme volatility. He felt strongly that power laws (curves with long tails) are more common in nature than “normal” statistical bell curves.

The violent market movements since 2008 suggest that Mandelbrot was more right than mainstream finance theory. The Nobel laureates that founded the hedge fund LTCM never expected market movements of more than four times standard deviation, but the Russian crisis in 1998 moved markets so much that LTCM ran out of liquidity before prices reverted back to normal. The lessons of LTCM were forgotten by market players and regulators alike in the run up to 2008.

How do we use Mandelbrot’s insights to look into 2012?