Ordered fear plays a strong role in market chaos

Jun 08, 2011

When the current financial crisis hit, the failure of traditional economic doctrines to provide any sort of early warning shocked not only financial experts worldwide, but also governments and the general public, and we all began to question the effectiveness and validity of those doctrines.

A research team based in Israel decided to investigate what went awry, searching for order in an apparently random system. They report their findings in the American Institute of Physics' journal AIP Advances.

The novelty of their study is the incorporation of time variation of "human factors" into . The team, led by Dr. Yoash Shapira, former head of the Atomic Energy Commission Research and currently a guest scientist at Tel Aviv University, along with Eshel Ben-Jacob, a professor of physics, Tel Aviv University School of Physics and Astronomy, and his doctoral student Dror Y. Kenett, hypothesized that temporal order (arrangement of events in time) should be hidden in variables associated with fear, such as .

They analyzed the volatility time series of 10 different from seven countries over a period of about 50 years and, rather than following traditional economic analyses, they analyzed time variations in the volatility—or the "volatility of volatility," a.k.a. "fear volatility".

In all markets studied, analysis revealed the existence of hidden temporal order in the volatility and very high correlations between the volatility and the magnitude of price variations. This marks the first time hidden temporal order has been found in these market "human factors."

"To a non-economist, economic theories seem decoupled from human reality. The fundamental assumption is that investments are made rationally. But investors can behave irrationally—driven largely by greed and fear, and other human factors," explains Ben-Jacob. "It's also odd that many mathematical analyses, such as the design of investment portfolios, assume no memory. It's assumed that stock prices behave with no apparent temporal order. Yet investors, including professional traders, take into account past behavior and are particularly influenced by the variation in prices or the volatility associated with the fear index."

The existence of such volatility order, or "ordered fear," implies that proper portfolio design should take into consideration the "volatility of volatility," according to the team. For example, the common approach to reducing risk is to select stocks with negative or low correlations in their sequence of returns. The new findings suggest that selection criteria should incorporate the correlations in the stocks' volatility dynamics.

"We're working on incorporating into market analysis," Ben-Jacob says, "by constructing a new parameter to replace the traditional systemic risk parameter."

Explore further: Copying behavior in social groups may be governed by optimal control theory

More information: The article, “Hidden Temporal Order Unveiled in Stock Market Volatility Variance,” by Yoash Shapira, Dror Y. Kenett, Ohad Raviv, and Eshel Ben-Jacob, appears in the AIP Advances.

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not rated yet Jun 08, 2011
2.3 / 5 (3) Jun 09, 2011
There were lots of warnings: the earliest indicators were that the Fed stopped reporting M3 and house prices became unaffordable relative to incomes, then house sales and prices stalled, Citigroup started to fall massively without obvious reason, the Euro went wild against the dollar, the Treasury bond yield curve went inverted, oil and gas prices spiked without fundamental explanation, as did other commodities, the Baltic Dry index was in free-fall .... all this was evident at least 6 months before September 2008, and sometimes much more. Even in the first months of 2008 talk of a recession was heavily on TV. The precise timing and depth of the acute phase of the disaster was unpredictable, but lots of people saw it coming. Some of the effects were surprising - the rush to the dollar, the capitulation of Congress, etc., but the overall impending doom was clear.
1 / 5 (1) Jun 09, 2011
It's a truism that markets are driven by expectations and emotions, with a bow to past performance. I don't think the article writer understands this. Rest assured, Goldman Sachs' mathematicians have been looking for the holy grail of "temporal order" in the stock market for decades. ... The writer's claim that the recession came as a complete surprise is false. Many many economists -- NYU's Nouriel Roubini and private analyst John Williams come immediately to mind -- publicly predicted the meltdown years before the event. (For that matter, a demographer whose name I've forgotten correctly predicted, in 1985 or so, that the US housing market would peak in 2007, from which you could derive the rest.)

For a better understanding of what the study was about, reading the PDF is recommended.

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