Stock market trends have long been associated with animal metaphors: bulls and bears. This century has seen the addition of another species, the black swan, which represents rare catastrophic events that engulf all financial markets. Not everyone loses when black swans land. In Chaos Kings: How Wall Street Traders Make Billions In The New Age Of Crisis, American journalist Scott Patterson hijacks the obscure world of traders and hedge funds who profit from doomsday scenarios such as the global financial crisis of 2008.
Financial markets are often associated with speculation, greed and excess in the general perception. When these layers are peeled off, an area emerges at the interface of mathematics and physics. In 1900, French mathematician Louis Bachelier used the concept of Brownian motion to explain the random movement of stock prices. A few years later, Albert Einstein used the same idea in his seminal work. It is this area of financial markets that Patterson examines. Where else could you find iconoclasts who despise conventional financial market wisdom and are willing to strategize to take advantage of the chaos?
The book revolves around two main characters: Nassim Nicholas Taleb and his hedge fund partner Mark Spitznagel. Taleb, more than anyone else, has popularized the term “black swan” in one of his top books. Spitznagel, a reticent trader familiar with the US commodities market, scoffed at modern portfolio theory (MPT), the basis of the conventional investment approach. A principle of MPT is that there is a trade-off between risk and reward. You cannot increase returns without taking on more risk at the same time. Spitznagel believes it’s possible to increase returns while reducing risk. His track record as a hedge fund manager suggests he’s on to something.
Taleb and Spitznagel’s philosophy can be summed up in three steps. First, anything can happen (read black swans). Second, extreme events are more devastating than assumed. Third, it means that markets are undervaluing these risks, creating opportunities for profitable deals to be made. Taleb, who always lacks succinct quotes, believes, “The lack of knowledge should give you more confidence about what to do.”
It is a strategy based on the principle that a crash is inevitable but the timing is unknown. Not everyone believes that. This is where mathematicians come in, looking for patterns that lead to accurate predictions about crashes. Some of them claim to have discovered recognizable patterns using tools from other disciplines.
At this point, another French mathematician, Didier Sornette, enters the scene in the book. In 2003, he wove chaos theory, fractal geometry, behavioral economics, and earthquake science, among others, to explain why stock markets crash.
One of the lesser-known aspects of financial research is the interest it has sparked among French mathematicians, whose curiosity takes them beyond the narrow confines of their discipline. Benoit Mandelbrot, Taleb’s friend and pioneer of fractal geometry, believed that conventional finance was based on an inappropriate branch of mathematics. It was not the possibility of money that attracted him to financing, but the mountains of data that he could use.
If Bachelier’s work marked an interdisciplinary turning point in 1900, is there a possibility that the strategies of the Chaos Kings could provide insight into a field like climate science? Ultimately, this may be where the true value of financial market professionals lies.
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This article appeared as an editorial statement in the print edition of The Times of India.
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