What is Chaos Theory?
For the uninitiated, chaos theory can be classified as a complex mathematical theory that seeks to shed light on the effect of factors that appear to be insignificant. This theory is meant to explain why random – if not chaotic, occurrences arise. It is frequently applied to financial markets along with other complex systems such as determining what the weather for the next few days or weeks will be. Chaotic systems appear predictable for a certain amount of time following which they begin to appear as though they are random.
Examining the Beginnings of Chaos Theory
A meteorologist named Edward Lorenz is credited with conducting the first real experiment pertaining to chaos theory. This meteorologist employed a number of equations in order to predict the weather. The year 1961 witnessed him seek to recreate a previous weather sequence with the aid of a computer model that utilised 12 variables that included temperature and wind speed. These values were then placed on a graph with lines that rose and dipped over time. While he repeated an earlier simulation during this time, eventually he began to round off the variable values to three decimal places as opposed to six. Although this was a minor change, it radically transformed the pattern of simulated weather applicable to the two months under consideration. In this manner, Lorenz was able to prove the fact that factors that appeared to be insignificant could in fact have a major impact on the broader outcome.
Chaos theory, therefore, seeks to examine the results that small events can drastically instil upon events that appear unrelated.
Chaos Theory x Stock Markets
There exist two popular myths that pertain to the stock markets. One of these focuses on classical economic theory and states that markets are unpredictable and efficient in their entirety. The second myth is based on the theory that to a certain degree markets are in fact predictable owing to which big trading houses and investors are able to make consistent profits.
The truth, however, lies in the fact that markets are far more complex and are governed by chaos. Markets are made up of systematic as well as random elements owing to which forecasts made within the stock markets are precise only up to a certain extent.
As Edward Lorenz showcased, complex chaotic systems are susceptible to being influenced by minor alterations which can, in turn, disrupt a given system and can lead it away from an equilibrious state. The dynamics that govern market systems can be understood to be two elementary feedback and causal loops that impact and influence various segments of the stock market. To understand this better, consider a positive feedback loop that reinforces itself which is explained in the following example. Take, for instance, one variable that is affected by a positive occurrence increases another variable which in turn also enhances the first variable. This results in the system witnessing exponential growth which propels it forward and away from its equilibrium. This ultimately results in the system collapsing. On the flip side, a negative feedback loop is also capable of triggering a similar sequence of events however the system reacts to a change and works in the opposite direction.
It is not necessary for periods that are characterised by a high level of uncertainty to be owed to system dynamics alone. Floods, earthquakes, and natural disasters along with other environmental factors are also capable of causing volatility within the markets and leading to sudden drops in the value of a single stock.
In the realm of finance, chaos theory operates with the argument that price serves as the last factor to change for security. When chaos theory is applied, the change in price is ascertained via mathematical predictions that take into account the following factors –
- The variations in volume
- The momentum that propels forward changes
- The pace at which changes accelerate
- Personal motivations that govern a traders actions include hope, desire and doubt which are each complex and nonlinear emotions
Although some theorists are under the impression that chaos theory can help investors to enhance their performance, the application of this theory itself to the realm of finance remains controversial. This theory has been utilised with far more vigour in the realm of science. However, owing to the rate at which instability and randomness have begun to impact financial markets, there has been a rising interest in chaos theory from a finance point of view. Understanding the possibilities it provides, the limitations it poses and its relation with economic theories that have reigned supreme traditionally is key.