Didier Sornette - Why Stock Markets Crash (2003)

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By one estimate, 90% of international transactions were accounted for by trade before 1970, and only 10% by capital flows. Today, despite a vast increase in global trade, that ratio has been reversed, with 90% of transactions accounted for by financial flows not directly related to trade in goods and services.

Didier Sornette
Knowledge is encoded in models. Models are synthetic sets of rules, and pictures, and algorithms providing us with useful representations of the world of our perceptions and of their patterns.

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The same basic ingredients are found repeatably: fueled by initially well founded economic fundamentals, investors develop a self-fulfilling enthusiasm by an imitative process or crowd behavior that leads to an unsustainable accelerating overvaluation.

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According to the academic world view that markets are efficient, only the revelation of a dramatic piece of information can cause a crash, yet in reality even the most thorough post-mortem analyses are typically inconclusive as to what this piece of information might have been. For traders and investors, the fear of a crash is a perpetual source of stress, and the onset of the event itself always ruins the lives of some of them.

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Profiting from being in the minority leads to interesting paradoxes. Rather diabolically, if all traders use the same set of rules, they will end up doing the same thing at the same time and cannot therefore be in the minority.

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The concept of a random walk is simple but rich for its many applications, not only in finance but also in physics and the description of natural phenomena. It is arguably one of the most founding concepts in modern physics as well as in finance, as it underlies the theories of elementary particles, which are the building blocks of our universe, as well as those describing the complex organization of matter around us.

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It is difficult to assess how much this gambling spirit is active in the minds of individual investors. If it is, even to a small degree, it is relevant to our discussion since it makes investors prone to imitation and herding because they invest on little information. It may also explain the anomalously large volatility of prices and their potential instabilities.

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The price of a stock is strongly influenced by the behavior of the traders in a nontrivial way.

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These rumors do not circulate in all directions, but essentially from the top to the bottom of society. The rather sophisticated presentations, the apparently serious references that seem to justify their origins, and their distinguished proponents provide food for amplifications serving diverse interests and psychological biases in all layers of society.

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One trader's move in the market can be interpreted by another trader as relevant additional information due to the uncertainty he faces.

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At another level, market crashes constitute beautiful examples of events that we would all like to forecast. The arrow of time is inexorably projecting us toward the undetermined future. Predicting the future captures the imagination of all and is perhaps the greatest challenge.

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Faster-than-exponential growth also occurs in computing power, as measured by the evolution of the number of MIPS per $1,000 of computer from 1900 to 1997. Thus the so-called Moore's law is incorrect, since it implies only an exponential growth. This faster than exponential acceleration has been argued to lead to a transition to a new era, around 2030, corresponding to the epoch when we will have the technological means to create superhuman intelligence.

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Indeed, the frequency of crashes in the Monte Carlo simulations was much smaller than the frequency of crashes in the real data: if one of the most frequently used benchmarks of the industry is incapable of reproducing the observed frequency of crashes, this indeed means that there is something to explain that may require new concepts and methods.

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Positive feedbacks, when unchecked, can produce runaways until the deviation from equilibrium is so large that other effects can be abruptly triggered and lead to ruptures and crashes.

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The incentives that people need to work and to find meaning in their lives should be found beyond material wealth and power.

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Finally, empirical data suggests that assets are sold much more slowly during retirement years than when they are accumulated during working years.

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The assumption of perfectly rational, maximizing behavior won out until recently in the art of modeling, not because it often reflects reality, but because it was useful.

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Since it is the actions of investors whose buy and sell decisions move prices up and down, any deviation from a random walk has ultimately to be traced back to the behavior of investors.

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A bubble that goes up is just one that could have crashed but did not.

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The problem is not that this optimistic view is wrong. By economic accounting, the optimistic view is mostly right.

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Indeed, the financial world is such that any insight is almost immediately used to trade for a profit.

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Perhaps the most profound synthesis of physical sciences came from the realization that everything could be understood from "conservation laws" and symmetry principals.

Didier Sornette
The old Wall Street saying " buy on rumors, sell on the news," is alive and well, as can be seen from numerous sources in the media and the Internet. Rumors can drive herding behavior strongly.

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In order to have a continuing influence, the stock market has to continue rising at an accelerating pace faster than exponential. Only a faster-than-exponential stock market growth makes private investors feel richer.

Didier Sornette
The point is that humans are rarely at their best when they use rational reasoning.

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