Chaos Theory and the Stock Market

Are markets random in nature? Neoclassical economists have introduced theories such as the efficient market hypothesis and random walk theory that led to the contemporary passive investing boom. If the stock market returns were indeed random, they would follow a normal distribution. Trader turned author Nassim Taleb calls the application of the bell curve to financial markets “that great intellectual fraud,” and for good reason too. Firstly, the application of a normal distribution and its implied mean, variance, and standard deviation has had disastrous consequences because normal distributions underestimate actual risk in markets. Portfolio insurance in 1987 amplified that year’s flash crash and the implosion of the highly leveraged Long Term Capital Management in 1998 nearly crippled the global financial system. Both relied on underestimated standard deviation as a measure of risk.

Secondly, empirical evidence shows that stock market returns do not follow a normal dis…

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