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50 Wilmott magazine
BENOIT MANDELBROT
elite École Normale using purely geo- thinker who had the luxury to take than the theories of financial econo- strategy of going straight to practi-
metric intuitions (this should be a his time to grow his ideas. mists, and, which is worrisome, tioners and the general public and
hint for educators: consider how (Charmingly, BM, in his scientific more understandable by the common bypassing the academic establish-
much more intuition you can devel- writings, when discussing a contri- man more than by the classically ment, a task that might appear easy
op with images instead of words). But bution made by a mature mathe- trained economist – just as the com- with economics given that the
he left after two days. Already stub- matician, mentions his age, such as puter graphic designer or a comput- public and professional standing of
born, unruly and unmanageable, he “Cauchy, at the age of 64...”). It is erized teenager could get the point economists in general and finance
moved to the more engineering-ori- thanks to such maturation that he far more easily than a classically academics in particular is one of
ented École Polytechnique. He then joins that category of the classical, trained mathematician. the lowest of any specialty. So the
settled in the United States, working pre-academic specialization of It is not a well-known fact that mission of toppling these fake
most of his life as an industrial scien- the wisdom-generating natural before his involvement with the and empirically invalid beliefs
tist for IBM, with a few transitory and philosophers. roughness in the geometry in seems trivial.
varied academic appointments. What does it all have to do with nature, BM started his career focus- Or is it? Finance academia,
Indeed, thanks to the computer, he finance? Can we extend the concept ing on problems in social science unlike the physics establishment,
could let the potent machine express of fractals and self-similarity to sta- and finance; it is certainly there that seems to work more like a religion
his geometric hunches and lead tistical frequencies? It would make most of his ideas were refined. He than a science, with beliefs that have
through the subject matter’s natural the concept of astonishing universal- initially wrote papers in the 1960s so far resisted any amount of empiri-
course. Indeed, the computer played ity. This would make BM the true presenting his ideas on “infinite cal evidence (actually this statement
two roles in the new science he Kepler of the social sciences. The
helped conceive. First, these fractal
objects, as we will see, could be gen-
analogy to Kepler is at two levels,
first in the building of insights This would make BM the true
erated with a simple rule applied to rather than mere circuitry, second
itself which is ideal for the automa-
tion of a computer (or mother
because you can step on his shoul-
ders – the title of Kepler or “Newton
Kepler of the social sciences ...
nature). Second, in the generation of
visual intuitions lies a dialectic
of the social sciences” is one so many
thinkers with grand ideas have tried
first in the building of insights
between the mathematician and the
objects generated. A mathematical
to grab (Marx for one aimed at being
the Newton of the sciences of man). I
rather than mere circuitry,
scientist par excellence, in a subject
matter that did not (then) exist insti-
am not in the business of defining
genius, but it seems to me that the second because you can step
tutionally, he was held to be a mathe- mark of a genius is the ability to pick
matician for scientists and a scientist
(particularly a physicist) by the math-
up pieces that are fragmented in
people’s mind and binding them
on his shoulders
ematical establishment. And while together in one, a meta-connection variance”, getting some early accept- is quite mild; it works just like a reli-
mathematicians burn out in their of the dots. ance, but rapidly causing anxiety in gion totally impervious to news
twenties, he received his first aca- Do probabilities (more exactly, financial economics circles. He then from reality). The closest field to
demic tenure at Yale when he was 75 cumulative frequencies) scale like moved to the less harmful fields of finance in the history of science
years old. Indeed, after a stint at cauliflowers? If so, the implication is geometry and physics, returning to would be pre-Baconian medicine as
Harvard where computer and mathe- not trivial as we may be on to some- finance in 1995 when he started a practiced in the Middle Ages, either
matics are subjected to a conceptual thing general, working across sci- very active production of scientific disdainful of observations or spin-
separation, it is at Yale that BM6 got ences and fields. And if so, then the papers on financial risk. At eighty, ning them with theological argu-
his dream job as a Professor of statistical attributes of financial he shows no sign of relenting, pro- ments. financial theory being a fad,
Mathematical Sciences. And it took him markets can be made far more ducing, as I said, the deepest and not a science, it will take a fad, and
half a century to fully realize what understandable than by the compli- most realistic finance book ever not necessarily a science, to unseat
his work was united by an attribute: cated and middlebrow so-called printed. By writing The (Mis)Behavior its current set of beliefs.
roughness, not just as a quality of “Gaussian” framework. Indeed there of Markets in collaboration with BM wrote his doctoral thesis on
objects, but as a standalone field of is something about BM’s work that Richard Hudson, a long time jour- what seemed to be two subjects at
study. It is impressive to see him as makes him and his ideas far more nalist at the Wall Street Journal, he once: mathematical linguistics and
the embodiment of a scientific understandable to the common man seems to be employing the same statistical thermodynamics (de
Wilmott magazine 51
BENOIT MANDELBROT
Broglie was the head of the thesis would the arrival of Bill
committee). Before the advent of Gates to a town do to the average
Information Theory as a discipline, wealth there.
such mixing seemed quite strange. A It is worrisome because every
quip goes to the effect that, of his student of statistics learns about
two topics, the first did not exist yet mean and variance as the founda-
and the second no longer existed. tions of their methods.
But the unity between the two was The Gaussian, in contrast, is not
the so-called “fat tails” and “power scalable. Most observations hover
laws” that are now becoming around the mediocre, and devia-
increasingly popular in physics and tions either way become increasing-
social science, though not in eco- ly rare, to the point of there being
nomics. The spark came from the so- events of an impossible occurrence.
called Zipf’s “law” in linguistics, Take the number of adults heavier
after the works of one George Zipf than 300lbs and those heavier than
on the relative ranking in the fre- Figure 1 The Cauliflower theory of frequencies. This is the result of the application of 150lbs. The relation between the
power laws dynamics to a wealth process. If you divide the area in smaller ordered sub-
quency of words in a vocabulary. BM samples, you will see the same inequality prevailing. two numbers is not the same as the
debunked Zipf’s belief in the separa- one prevailing between 600 and
tion, thanks to these laws, between with wealth in excess of 20 million wars, and, of course, market move- 300lbs. The latter will be consider-
social and the natural sciences: will be approximately the same in ments. The implication of these able smaller. It gets smaller as the
these “fat tailed” phenomena also relation to those with more than 10 power laws is that, for most, there is number get larger – meaning that
existed in physics. We are just blind million: about a quarter. This rela- generally no “standard” deviation there is no self-affinity. Deviations
to them. tion (here the square of the ratio) is from the norm. In the previous from the norm decrease very rapid-
BM later built on the works of called a scaling law, as it is retained example of wealth, if there are more ly, at an increasing rate, to the point
the (then) unknown mathematician at all levels, no matter how large the than 1/4 the number of people with where some high number becomes
Paul Lévy and, to a lesser degree, the number becomes (say two billion in a 2 times a given level of wealth than literally impossible. The increase of
trader-economist Wilfredo Pareto to relation to one billion). What is criti- with a given level (more technically, the rate of the decrease is what pre-
whom the original power law is cal here is that it does not vanish – when the tail exponent is higher vents scalability. BM calls this type
attributed. The designation “L- frequencies get lower for higher than 2 since doubling the wealth of randomness “mild”, as compared
Stable” distributions, (for “Lévy- wealth levels, but the ratios between threshold here leads to an incidence to the “wild” one generated by
Stable”), a.k.a. Pareto-Lévy distribu- two arbitrarily high numbers do of more than the square of the ratio), power laws. There is a beautiful sen-
tions comes from Mandelbrot. I pre- not decrease! then we are dealing with undefined tence in the book differentiating
fer to use the designation “PLM” Cauliflower? If you separate the variance. Now, worse, when the fre- between the two: “Markets often
(Pareto-Lévy-Mandelbrot) for the frequencies you will find that the quency in the previous example leap, don’t glide”.
more general case of a random series sub-samples resemble each other in drops by less than half, then we are To further see the link between
with both independent and non- the degree of inequality in the differ- in a situation of extreme fat tails: finance and fractal geometry, pick a
independent increments. ent ordered sub-sections, as can be there is no known average. Any arbi- financial chart. Just like the coast of
Let us see how power laws, with shown in Figure 1. trary large number can take place Britain, self-similar at all resolu-
their scalability, i.e., the asymptotic Note that the “tail” is the point that can disrupt the mean. The con- tions, monthly prices look “like” (i.e.
settling of a series to a constant limit where the outcomes become scala- cept of average is meaningless, total- present an affinity with) hourly
in the relationship between likeli- ble in cumulative probability; it does ly meaningless as a characterization charts. One has to shrink the
hood of events, can be seen as an not have to be a transition point (it of the attributes of a very fat-tailed timescale more than the price scale
application of fractal geometry. can be an asymptotic property as we process, such as computer firms. The in order to get the same effect.
Consider wealth in America. tend towards it). This scalability notion of a “typical” computer com- Furthermore, if the stretching is
Assuming we reached the “tail” , the seems to apply to a variety of phe- pany has nothing to do with any- done in a random manner, itself
number of people with more than nomena like book sales, nodes on thing. Likewise characterizing a fractal, one ends up with what
two million will be around a quarter Google, the relative size of cities, the “typical” writer provides no infor- Mandelbrot calls multifractal.
of those with more than one mil- number of times an academic paper mation. Just consider how unstable In 1963 BM wrote a paper on the
lion. Likewise the number of persons is cited, the number of casualties in these variables can be: imagine what properties of financial prices and
52 Wilmott magazine
BENOIT MANDELBROT
found them to be scaling power laws ment, you may not be diversified as very sad history of modern finance. memory – in other words we are no
of the anxiety-causing types – the much as conventional theory indi- It ends with the presentation of the longer dealing with serially inde-
“infinite variance” variety. The paper cates. And conventional statistical evidence against these models. It pendent draws. The mathematics is
was initially endorsed by the ortho- theory might make you jump to con- does not take a lot of empiricism to more intuitive and more realistic
dox finance establishment, accept- sequences too quickly: your sample figure out that such risk measure is than what we are used to; indeed
ing the implications that there is not size is smaller than you think. useless: the stock market crash of there is no mathematics but graphs
“standard” risk, no known risk. But I was trying to explain the differ- 1987 had, according to their models, and geometric intuitions. He pres-
suddenly, these academics started ence between two modes of thinking, such a low probability, one in several ents the usual attacks on his model
looking the other way as “modern the broad and the narrow, to an billion billion billion years , that it that consist in saying, “daily prices
portfolio theory”, linking risk and investor. Remarkably, it corresponds should not have happened (probabil- might be nonGaussian but in the
return, was born. There had to be a to the difference between power laws ities that low are no longer measura- long term things become Gaussian”.
measure of risk, even if it presents the and Gaussians. As a method of risk ble; it is meaningless to argue Long term? After the bankruptcy?
fatal contradiction of not working management, he follows the conven- whether to assign a 10-23 or a 10-12 Long Term Capital Management
when you need it. The bell curve tional methodology of collecting probability to these). You do not was a “long term” idea as well.
describes the equivalent of the odds past returns, building a database, need a lot of empirical work to real- Under leverage there is no such
of an uncomfortable airplane ride, and simulating by drawing from the ize that a model is wrong: one single thing as long term.
nothing about the risk of crash – but past, thanks to bootstrapping-style instance suffices to invalidate it. The third part wraps up with
operators thought thanks to “sci- methods. Using such an approach Another piece of evidence more railing against finance theory
ence” they were now in control. would make him select the largest among many is the hedge fund and some suggestions for further
If you asked for the bridge possible deviation in the simulation Long Term Capital Management research. It includes a scene with
between the arts and science, the as the worst scenario. A method of that went bust in 1998. It employed journalistic overtones of a visit to
notion of fractal would come up. If say, fitting an “empirical probability 25 PhDs, and two “Nobel” medal- the laboratory of randomness spe-
you ask about what bridges hard and distribution”, would do almost the lists in economics for their work in cialist Richard Olsen in Zurich.
social sciences, the same scalable same. This is an interpolative finance. Aside from the fact that ***
laws would come up. Doesn’t this method – of course the worst possi- their “Nobel” was mistakenly pre- This book has a crisp message
make BM the universal scientist? ble move in the future is going to be sented for inventing a “formula” – about risk. The reviews were quite
Most of the effects of similar to the one in the past, though the formula has been there for a favorable, but distressing for us
NonGaussianism flow from the these moves did not take place in the while; what they did is make it fit empiricists as few commentators
consequence that a small number of past’s past. After the stock market into the prevailing economic argu- got the point. People have difficulty
observations might contribute dis- crash of 1987, they simulate using 22 ments. They used complicated dealing with the idea that one can
proportionately to the total mean per cent as the worst daily deviation. mathematical models – they should write a general book on a financial
and variance. Pending on the gravi- Don’t they realize that before the have had on their staff more street- topic without telling people about a
ty, you either need a very large, possi- crash they would have used the pre- smart cabdrivers who do are privi- new foolproof (and secret) tech-
bly infinite, sample to track the ceding worst case and missed on leged to not know economics. LTCM nique about how to double their
properties. Indeed, if ten days in a such a big event? is a milestone as a catastrophe that money in 21 days. My book Fooled by
decade represent 40 per cent of the Both the Gaussian and our con- was caused by the pseudo-science of Randomness generated hundreds of
returns, which we tend to see rou- ventional wisdom are interpolative. economics, much like the side letters with the following class of
tinely with financial securities, Power laws are extrapolative. You effects of those medieval medical complaints: “you tell us that it is
much of conventional sampling the- look at the ratio of millionaires to remedies. mostly luck, which seems reason-
ory goes out of the window. Consider bi-millionaires and can translate it The second part discusses the able, but you don’t tell us how to
that under a Gaussian regime, since into the ratio of 10-millionaires to fractals theory and its relation to make money out of this luck”.
these outliers represent a small 20-millionaires. Likewise the ratio the power laws. Those familiar with People are so conditioned by advice-
share of total variations, you should between 5% and 10% moves allows BM’s ideas from James Gleick’s offering charlatans in business
be able to obtain the properties of , you to infer the incidence of moves Chaos will see the usual themes pre- books that anything remotely away
say, the stock market by being in it a in excess of 20%. sented. It ends with the multifractal from it seems, as I was told, quite
small sub-segment of the time. I will rapidly go through the model where BM presents a memo- “odd”. BM’s, of course, does not give
Diversification, too suffers from the details of the book . ry of prices similar to those of the you a recipe. It was therefore amus-
consequences of scalability. Since fat The first part of the Mis-Behavior of floods by the Nile river; what hap- ing to see the book reviews com-
tails create a winner-take-all environ- Markets, out of three, presents the pened a decade ago stays lurking in plaining about the “now what?” –
54 Wilmott magazine
BENOIT MANDELBROT
how can we take these ideas home? fined variance”), implies that when the Swedes for his GARCH process, “mean-divergence” , and the other
The answer is clear: get out of the you take a sample from a long series, made the following comment: more gullible “short volatility” who
markets as we understand them every sub-sample yields a different whether or not you include the stock believe in models, “mean-reversion”,
less, far less than we are led to measure of volatility. market crash of 1987 or not makes a “arbitrage”, the self-canceling activi-
believe. That would be a significant Nor does it look like the fudging huge difference to the choice of ty called statistical arbitrage, and
first step. What this book is about is of the finance models can produce model and its parameters. GARCH, similar things. In other words, there
the variability of markets and their real results. I will omit discussing extremely fragile in its calibration, is the naive and the skeptic.
risks, period. the repackaging of the Capital Asset is very sensitive to the inclusion of Scientists and academics tend to
The central idea about risk man- Pricing Model under the newer such large observations from the squarely fall in the second category,
agement that preoccupies me cur- “Arbitrage Pricing Theory”, except to deep past. Does it smell like unde- even when they trade, while veteran
rently is as follows. If you save peo- bemoan that, seven years after fined variance to you? traders and real practitioners have
ple in the process of drowning you LTCM, the most recent issue of the I am dedicating my next book, the first mindset. It was a surprise to
are considered a hero. If you prevent Journal of Economic Perspectives7 cele- The Black Swan, to BM for his 80th encounter BM, a scientist of the
people from drowning by averting a brates with some pomp the 40th birthday. I can now safely say, in “long-vol” category.
flood you are considered to have anniversary of Modern Portfolio spite of my having had discussions It was also refreshing to find
done nothing for them. Such asym- Theory. It is saddening to see that so with hundreds of hotshots, that he someone who shared the same aller-
metry is apparent: you do not get few realize its epistemological dan- is the first person who ever taught gies. It was not just the notion of
bonus points for telling agents to gers. One insightful and honest arti- me anything meaningful about my variance; small details can be reveal-
avoid investing. They want “some- cle, by Fama and French, talks about subject matter of uncertainty. More ing. For instance, we both got inde-
thing tangible”. the poor “empirical” results, accept- specifically, it was the first time in pendently offended by the same
Likewise you do not go very far
by telling people “we do not gain
anything by talking about the vari- People readily mistake irreverence towards some
ance”. They want a risk number, a
correlation number and BM takes it
away from them (notice that unde-
class of accepted heroes for arrogance. A fair
fined variance also means unde-
fined correlation).
approach would be to examine the targets of
A simple implication of the con-
fusion about risk measurement
such irreverence
applies to the research-papers-and-
tenure-generating equity premium ing the notion that empirical my life that I had a conversation statement that “nature does not
puzzle. It seems to have fooled econ- implies in practice, out of sample and with someone who can naturally make jumps”.
omists on both sides of the fence realizing that, in the end, its appeal hold that the notion of “variance” is So time lost was made up and it
(both neoclassical and behavioral lies far more in teaching MBA stu- meaningless in characterizing was refreshing to discover the per-
finance researchers). They wonder dents than anything else. uncertainty – and we could move on sonal charm of the universal philoso-
why stocks, adjusted for risks, yield Now there have been fixes to to a more meaningful discussion of pher and be privileged to his conver-
so much more than bonds and come these equations to accommodate fat- the subject. I finally found someone sation partner. BM only lives five kilo-
up with theories to “explain” such tails, to no avail. Every option trader I could talk to without feeling deep meters away from my house, which
anomalies. Yet the risk-adjustment knows that volatility is variable – but strain and tension. means that we spent more time talk-
can be faulty: take away the models such as GARCH, with close to There is more. He could commu- ing on the telephone than meeting
Gaussian assumption and the puz- 10,000 academic publications, do nicate with the trader in me. I was in person (this is how these things
zle disappears. Ironically, this sim- not seem to bring us closer to any- taken aback by how easily his ideas work). Conversations with him are
ple idea makes a greater contribu- thing. Making volatility variable is spoke to me, down to the very practi- punctuated by opened-and-closed
tion to your financial welfare than more complicated than we think: cal. We traders divide persons into parentheses, with tours of classical
volumes of self-canceling trading there is the problem of the specifica- two categories: those with a “long literature, history, science, music,
advice. tion of such variability. At the last volatility” frame of thought, who, in back to science, with digressions
The possibility of “infinite vari- ICBI Madrid Derivatives Convention, general, never rule out blowups, rarely left hanging. Not surprisingly,
ance” (or more appropriately “unde- Robert Engle, freshly medalled by change, trends, conspiracies, and he is an independent thinker in just
Wilmott magazine 55
BENOIT MANDELBROT
56 Wilmott magazine
BENOIT MANDELBROT
marized as follows: we do not observe take into account the probability of the squared Gaussian variate) . Talmudic scholar), explains quite
probability distributions, only ran- the candidate distribution being the This is exceedingly circular and eloquently that being an option
dom draws from an unspecified gen- wrong one. You can use priors and reflects a severe lack of awareness of trader gives someone a philosophi-
erator. So we need data to figure out probabilize with series of meta-prob- such circularity. cal approach along “long gamma”
the probability distribution. How do abilities. Neither handy, nor con- lines, or, more formally in the deci-
we gauge the sufficiency of the size of vincing, and it implies as Elie An easier solution sion theory literature: along a mind-
the sample? Well, from the probabili- Ayache2 put it in this magazine “try- As an operator first and last, I believe set focused on the convexity of pay-
ty distribution. If at the same time ing to find a random generator that there are, however, far more ele- offs. One comment I make here
one needs data to figure out the prob- behind the random generator”. And mentary (and practical) ways to deal about Tony is that his definition of
ability distribution, and the probabili- it does not escape the attacks by clas- with this problem, or at least to pro- philosopher is similar to mine (and
ty distribution to figure out if we have sical Pyrrhonian skeptics: we seem to tect ourselves from its ill effects. Mandelbrot’s): a philosopher is
enough data, then we have a severe be either 1) justifying belief with ref- How? I propose two approaches. someone who specializes in ideas,
circular epistemological problem. erence of other belief, itself justified First, consider Pascal’s wager. We not in other people’s ideas – like
Note here that fat tails are conta- by other belief, all the way up until can change our payoff structure to stamp collecting. Professional
gious. If you combine two random some unargued dogma, which could accommodate what absence of philosophers can be like parasites.
variables each following a power law be fragile (in this case some “known” knowledge we suffer from, and with To Tony, like for me, being long an
distribution but with different expo- distribution or generator for the respect to which moments of the dis- option in the tail (or more generally “long
nents, the result is a power law dis- time series) 2) justifying belief some- tribution. For instance, if the data convexity”) eliminates the need to try to
tribution with, for tail exponent, the where in the loop with another pre- has “infinite” (or undefined) vari- figure out what we don’t know3. Only
lower of the two. Here we have two viously derived belief and falling ance, one can avoid exposure to such an option trader could understand
processes, one of finite, the other of back into severe circularity; finally 3) infinite tail by clipping the sensitivi- that – that’s what I am trying to gen-
infinite variance; accordingly the the regress may never end and we ty to the offending part of the distri- eralize to all decision making
infinite variance will prevail. stay at the beginning. bution. Purchasing a simple deriva- under uncertainty and convey to
A traditional philosophical way Note that the quantitative-statis- tive(say, an extremely out-of-the- nontraders in my forthcoming The
to deal with the regress argument, if tical literature is not thoughtful money call), if it such product is Black Swan.
one follows the epistemological tra- enough or self-critical “to be even available, may provide a solution. It is key that we operators and
ditions, would be to either 1) put wrong” on the subject. How? Our doubt can be targeted and reme- decision makers are capable of insu-
your hands up and bemoan the Conventional tests of normality died by transactions. Tout simplement. lating ourselves from nasty parts of
Problem of Induction, and find theo- study the square errors from a Second, what we call the mas- the distribution. It is a fact that a
logical arguments to have some Gaussian and use a Gaussian- querade problem. The data cannot portfolio constituted of securities
unquestioned belief or 2) proceed to inspired distribution (a special case tell us what is the probability distri- that have infinite variance does not
a systematic layering: One can pose a of the Gamma distribution, the Chi- bution generating it; but it can easi- need to have infinite variance. How?
meta-distribution, one that would Square, which is the distribution of ly tell us what such probability dis- If you are short a call spread with the
tribution is not (or is not likely to be), position strike K , described as short
and which moments of the distribu- a call struck at K , long another call
tions we may not be able to compute. at K + y, you are “short volatility”,
but you are not exposed to infinite
Portfolios, infinite variance, and variance. Your payoff is capped.
epistemic opacity Furthermore: the properties of your
What many academic philosophers strategy are not fragile to parametric
do not realize is that the limits of assumptions or choice of model.
some knowledge may be of small Note here, in the earlier thought
moment. I would rather use my ener- experiment, that the moments of
gy in changing my payoff structure the distribution are very precarious;
rather than getting into intractable the loss L (taken in Log returns) is so
issues and playing philosophaster. large that the moments are insensi-
My colleague, another option trader tive to the probability of the big loss
and empirical philosopher Rabbi π. Indeed the pair π L (probability
Figure 2: A dataset of 2,501 prices. What is the informational increase? Anthony (“Tony”) Glickman (also a times the payoff) is so large that we
Wilmott magazine 57
BENOIT MANDELBROT
may never care about the size of the some questions put to me in this under aggregation. There have been Point 1: The slowness in the rate
probability. It is so obvious that we magazine about skepticism and series of papers6 disagreeing with of convergence makes a cubic α
should work to control L – or, if we asymmetric knowledge4, I will use Mandelbrot’s early work and its con- very seriously NonGaussian.
can’t, to only enter transactions the argument that it is always easier clusions. Researchers tend to be If we accept that α is approximately
where such L can be controlled. to figure out what the distribution is “skeptical” about the Lévy regime 3, “outside the Lévy regime”, we are
Now the question: what if we not than what it is. Compare that to hypothesis producing, for more than still in trouble with respect to the
can’t insulate ourselves from such the attributes of humans: a criminal a quarter century now, “evidence” to convergence to the Gaussian. Finite
distributions? The answer is “do can masquerade as an honest citi- the effect that Mandelbrot’s early second moment implies conver-
something else”, all the way to find- zen; an honest citizen cannot as easi- characterization of infinite variance gence under aggregation, but we
ing another profession. Risk man- ly fake being a criminal. Many exten- is wrong – people seem to very badly need to remember that with α < 4
agers frequently ask me what to do if sions of this point are accepted in need a Gaussian in order for them to have an undefined 4th moment. The
the commonly accepted version of many fields: one single event consti- operate with the current academic implication is rather serious.
Value-at-Risk does not work. They tutes a catastrophe; one needs many framework. Their methodology is Consider that the 4th moment is the
still need to give their boss some days without an event to pronounce based on two arguments, first, the variance, corresponds to the error of
number. My answer is: clip the tails an environment as catastrophe-free. “observation” of α > 2 and, second, the measurement in the variance
if you can; get another job if you This asymmetry is at the core of the examination of the behavior of (what we option traders call the
can’t. “Otherwise you are defining skeptical empiricism: our body of the data when they lengthen the “Vvol”). It will be infinite! This
yourself as a slave”. If your boss is knowledge is more readily increased time observation period. implies a quite nasty rate of conver-
foolish enough to want you to guess by negative observations than by These studies are either inconse- gence. There will always be a
a number (patently random), go confirming ones. Remarkably, we quential or wrong in their infer- NonGaussian jump in the extreme
work for a shop that eliminates the can do something with this; it leads ences. First, it does not make much tail to make the tail scalable.
exposure to its tails and does not get us to a ranking of the robustness of difference whether or not we are in a Another way to view it is that the
into portfolios first then look for results. And remarkably, it is because Lévy regime since we don’t really observations that we are adding are
measurement after. Indeed if like me I elect to behave operationally as if stay in the Gaussian regime in the likely to be biased towards the mid-
you think that Modern Portfolio the market followed a Mandelbrot- parts of the distribution that matter. dle of the distribution, making it
Theory is charlatanism (as con- stable process that I can build portfo- Second, we do not “have evidence” converge in the body but much more
firmed by my trader’s observations lios that I am comfortable with. A that we are not in a Lévy regime. slowly in the tails. We can examine
and empirical research, and Mandelbrot-stable variable is simply Third, we need to go beyond the this quantitatively. Take α = 3. It is
Mandelbrot’s work), use portfolios here what is called a Levy stable, but “Lévy regime” and consider the easy to show7 that, in standard devia-
that do not depend on their meas- with non-serially independent draws Mandelbrot regime by lifting the tion terms, outside (Log (n), with n
urements. It is so easy to avoid traps. (what BM calls multifractal). We will too-restrictive assumption of inde- the number of observations, we stay
return to the situation. pendent increments. I will get into in a scalable regime. Even if you add
The asymmetric masquerade the details of the arguments next. up 1 million days, the Gaussian
problem The α problem
A power law (as we saw in the Take X a random variable, we have a
thought experiment) can easily mas- power law P [X > x0 ] ∼ O(x−α 0 ).
querade as a Gaussian but not the Clearly we are told that if the first
reverse (at least not easily). We can and second moments of the distribu-
reject the Gaussian more easily than tion are defined, i.e., α > 2, then,
we can accept it. More generally, a under aggregation the series
distribution with fat tails can show becomes Gaussian so we can use the
milder tails than its “true” proper- conventional tools of analysis. Note
ties, except, of course, when it is too here that this only holds if we have
late. It will even tend to do so. The independent increments.
small sample properties of these BM came up with papers in the
processes are such that we are not 1960s5 showing cotton prices with
likely to encounter large moves in tail α < 2, in other words implying
them. We can call that problem an Levy-stability; the distribution has fat
“epistemic headwind”. To answers tails and does not become a Gaussian Figure 3: The regime densities.
58 Wilmott magazine
BENOIT MANDELBROT
Wilmott magazine 59