Reaping from Stock Market Chaos

Published on 27th November 2007

The stock exchange is one of the best known chaotic systems in the world. Others are the weather, population growth, and climate. No one has been able to accurately predict the next state of these variables. With this status quo, how can one benefit from the chaotic and unpredictable nature of the stock market?

Chaotic behavior has been observed in a variety of laboratory experiments such as electrical circuits, oscillating chemical reactions and fluid dynamics. This has prompted scientists to come up with the Einstein theory. It suggests that everything is in motion and is vibrating in response to a master vibration. Chaos theorists also state that chaotic systems exhibit dynamics and are highly sensitive to initial conditions in what is called butterfly effect! Chaotic theory reveals patterns of order out of seemingly chaotic behaviors. Over a long period of time, an observed system will develop patterns within a non linear time series that replicates in future states. My point of view is actually informed from the fact that all the sciences proceed towards similar principles.

Some behaviors are thought to be random but not to the very experienced hawk eye. This is where the debate about the chaotic nature of the stock exchange comes along. Certainly, stock market behavior is not linear and predictions are not very accurate. Bearing in mind what theorists are presupposing, the sensitivity to initial condition means that initial vibrations lead to bigger vibrations. Small changes in initial conditions produce larger changes in the long run. The initial bullish markets that are now on the verge of death in the Nairobi stock exchange will eventually come back and they will be bigger. You can bet on it.

Mr. Jimnah Mbaru, chairman of NSE, was recently quoted in a local daily newspaper saying that you cannot go wrong on stocks. A rich man of his wisdom already knows that stocks will always vibrate making him richer with each vibration being bigger that the preceding one. This is the knowledge that rich people possess. You and I probably know this but we are doubtful.

Market bubbles which characterize the chaotic nature of the stock exchange remain a challenge to economic theory. It has been suggested that they are caused by processes of price coordination because the events are seemingly unrelated.  Another attempt was made by the greater fools theory which portrays bubbles as being perennially driven by optimistic investors who buy overvalued assets in anticipation of selling them to other speculators (the greater fools). There is also the famous Random walk theory which states that stocks have an irregular and unpredictable path. The true answer however lies in the chaotic theories. 

Another rule is that, you as the investor should buy stock when the prices are low then wait for capital gains. A good waiting period could range from anything close to twenty years.  Do not buy when the prices are high because you might be the greater fool. Invest in a mutual fund or directly in the market. Your game plan must be long term. Short term selling and its gains cannot compare with long term gains. It’s more like the education system where education must be imparted to you for 16 years before you are called a professional. 

The various asset bubbles that have been in the world are no strange phenomenon. They include the Japanese asset bubble (1986-1990), American stocks (1960-1970), and Chinese asset bubbles as of 2006. What these countries have in common is that they are economic giants and have experienced similar bubbles before and are now experiencing greater bubbles which will lead to even bigger bubbles in the future. Patience is a well documented success strategy that an aspiring rich investor must exercise.

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