Does Complexity Breed Volatility?

We have now become familiar with the VIX, the Chicago Board Options Exchange Market Volatility Index, thanks to the wild stock market volatility that has graced our television screens in the last few weeks.  Investors process incoming political and economic news, and try to assess their future implications on investments and assets.  They do so with limited information and limited knowledge.

The  Financial Times shows that increased volatility is caused by large investors correlating their bets, essentially, as Telis Demos quotes Nicholas Colas, chief market strategist at ConvergEx: “All the people on the boat are running from one side to the other over and over again”.   Buyers and sellers all agree on the direction of the market and interpret the news in similar manners all at the same time.

I submit – without much proof I admit – that this behavior is driven, in part, by the temporary inability of buyers and sellers to grasp the future implications of some news on assets, because the system is too complex – and they simply cannot isolate the impact of the news on their World.

In normal times, investors have a systematic view of their World that enables them to process news (weather, politics, war) and figure out the potential magnitude of the impact on the assets in their care (stocks, bonds, commodities, infrastructure, etc.)  Some see the news as good, some may see the news as bad, each may use a different model to predict what the future will bring.   But the system has become so complex that it has become increasingly difficult to build a functional model that can tell us what the impact will be with some certainty.  Take the debt ceiling case, for instance.  Was there a likelihood that the U.S. would be downgraded?  And what would be the significance of that? And how would that impact other countries?  And how would that impact S&P and the value of their ratings in other countries?  And ow would it affect municipalities in the U.S.? and their creditors?  And how would it affect the U.S.’ competitiveness in the long run?  And how would that affect the U.S. election?  And how would that impact the U.S. stock market in the medium term? …..too much to process….

In the end, investors will give up and follow the herd: sell when they sell and buy when they buy…until the news cools down again, and we can decompose ourselves into smaller, less complex, manageable Worlds.

Oh, by the way… the same idea applies to political candidacies… and volatility in political ideology, but that should be the topic of another blog…

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2 Responses to Does Complexity Breed Volatility?

  1. jonnydropout says:

    i agree. the financial markets have become overlays of themselves. trillions in electronic cash sloshing loosely beneath gray, anonymous static. i think the modeling breaks down because of the mechanisms of control are so vastly undersized when compared to the scale of the networks involved.
    but i think its more structured than pure behavior or complexity overload. the complexity was constructed carefully to have a fierce outer shell, but internally the complexity hides very simple crimes and scams, just in different terms and under the protection of private banks and corporations. the math underlying derivative trading is complex and difficult to understand, but the idea of placing bets on what will happen is a very old idea.
    i believe the trouble is now scale, where the amounts of money that move worldwide have become to unwieldy for the networks to handle without increasing fluctuation. the feedback loops among traders as trillions flood a market can create unintended panic among traders, and several firms have automatic sell or buy software monitoring the networks constantly, so the reaction to any action takes place without anyone asking.
    that…is a scary prospect.

    great post…

    Like

  2. Pingback: Perry, Obama, and Political Volatility « Complexity

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