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5This tool can be applied to analyzing web site traffic, click-throughs, ad performance and many others things. The mathematics of stock prices and traffic at a web site are closely related.Portfolio managers try to maximize returns for a given level of risk.
The problem is that the mathematical model that most portfolio managers use can easily be demonstrated to be very inaccurate.
The risk-reducing formulas behind traditional portfolio theory and risk management theory rely on unfounded premises that cause them to consistently underestimate risk:
- Price changes and other events are statistically independent of one another.
- All price changes and other events are distributed in a pattern that conforms to the standard bell curve. The width of the bell shape (as measured by its sigma, or standard deviation) depicts how far price changes diverge from the mean; events at the extremes are considered extremely rare.
Stock prices, interest rates, currency exchange rates, real estate prices, Internet traffic and any other economic and business data that you care to chart are not distributed on a normal curve. They are all fractals. If you are not familiar with this branch of mathematics this site has a introduction to fractals.
The problem with using a bell curves to predict risks is that they vastly underestimate the probability of large fluctuations that frequently occur in real data. By vastly I mean a factor of 1,000,000 or more. For example, the fluctuations in stock price observed when the stock market crashes are predicted to happen perhaps 1 in a 100 billion days by using a normal curve. In real life they occur about 1 in 37,000 days.
Fractal mathematics and chaos theory can't predict the price of stocks next month or whether your website will be down tomorrow but they can accurately predict the risk associated with investing money in stocks or the chance that your site will be down 50 hours in the next 6 months.
The reason that portfolio managers aren't wild about using fractal mathematics is that if many investors would be frightened away if they had an accurate picture of the risks involved. An investment that seems very conservative using traditional risk assessment methods often becomes a reckless gamble when using fractal mathematics.
How can you use this in real life?
In the case of using this approach as a tool to help make decisions, you are risking resources and money and looking for a return in money and resources.
- Risks of redundant failures of equipment and services are underestimated using traditional models. For example, web server failures are a fractal not a normal curve. This means that the chance of having two web servers set up to redundantly host a site are way more likely to fail at the same time in real life than traditional models would predict. The chance of two failing at once is still small, but if it results in total disaster scenario for your business it might be unacceptably high.
- There is much less difference between "risky" investments and decisions (such as investing in a startup company) and "safe" investments (such as investing in a mutual fund) than traditional methods suggest.
- Traditional models under predict risk of "safer" decisions so they overestimate the relative risk of "risky" decisions. This explains why are so many successful risk-takers in the Internet business. Nothing is worse from an investment point of view than taking a risk that is disproportionately high for the return. Underestimating risks or overestimating potential return (or both) result in decisions that cause risk to be high compared with potential returns.
- Traditionally "risky" ventures usually have a very large potential return. Given that the risk of any venture is large makes "risky" ventures more attractive. Risk is managed by taking many large risks each with a large return instead of one "safe" risk with a small return.
Many "experts" are using this to push such traditionally risky investment such as shorting stocks. Just because traditionally "safe" investments are worse than advertised does not make "risky" investments better ( they are even riskier than advertised). An example is that shorting stocks is still very risky, just less risky compared with mutual funds than traditional analysis indicates.
So where do you invest your money? The simple answer is, "only invest in things that have a positive expected return." I'd recommend finding a real mathematician to help you decide but here are things that are likely to have a positive expected return:
- Investments and other decisions that are super conservative (like CD's and savings accounts).
- Investments and other decisions with a very large potential return (like startup companies).
In between things tend to have the worst of both worlds, relatively low returns with relatively high risk. Most stock investments including 401(k)'s fall into this category. Fractal analysis predicts the type of losses that Enron employees and others that were heavily invested in 401(k)'s experienced in 2000. Learn from their experience and Mandelbrot's brilliant analysis.
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