Power laws, fractals and investor psychology. Why security prices behave like they do.
In this episode, you’ll learn:
- Why oil prices are falling
- How are oil prices set.
- What is a fever chart.
- What are fractals.
- What is a power law.
- Why do security prices follow power laws.
- What is an information cascade.
- What do you do when your investments are falling.
- Applying power laws in our own lives.
Why Security Prices Behave Like They Do
Oil prices have fallen over 40% since July. What triggered the decline?
I don’t know. Does anyone? Not really.
The most recent data from the the U.S. Energy Information Agency (“EIA”) shows that global oil production increased 1.4% for the year ending August 2014.
In North America, oil production increased 7.5% year-over-year, which means outside of North America oil production actually declined slightly.
A 1.4% increase in the supply of oil seems insufficient to trigger a 40% decline in price.
What about oil demand? The most recent data from the EIA only goes through July when prices started falling.
Let’s weave a plausible story for why oil prices are plummeting.
“Demand has tanked.”
Am I sure? No. I’m relying on basic economics, which says if supply stays roughly the same and prices fall then demand decreased.
Is that a true story? I have no idea. It’s only a plausible story.
The Right Price For Oil
How are oil prices set?
They are set by participants in the oil futures market, which is a trading venue comprised of thousands of individuals and institutions, some of who are trying to hedge their oil exposure and others who are simply speculating.
How do participants in the futures market determine the “right” price for oil today and in the future if no one has up to date oil production and demand data?
Which means there isn’t a “right” price for oil. There is just the price set by lots of guesses made by individuals who don’t have a clue what is going to happen next.
If I plotted the price of oil on a graph over time you would see it bounces around with spikes and drops, both small and large. This type of graph is called a fever chart.
Here’s an interesting phenomena with fever charts. If I erase the dates, prices and marks from the axes and only show the picture of the spikes and drops you would be hard pressed to determine the time frame.
In other words, a fever chart showing prices minute-by-minute looks similar to a chart showing prices hour-by-hour or day-by-day.
If I then take the price data used to construct the fever charts and graph the relative change in prices you would see that large price changes are not spread out evenly on the graph. Instead, they cluster together into periods of higher volatility where prices change dramatically.
Security prices for oil, stocks and other asset types are fractal. Fractals are geometric or mathematical patterns that repeat themselves at every scale.
Objects that are fractal are self-similar in that when the small objects that make up a larger object are magnified they look the same as the large object.
Examples of fractals in nature include broccoli, trees, leaves, coast lines, and the human lung.
A small piece of a broccoli spear if magnified looks similar to a large piece of broccoli.
An aerial photo of a mile of British coastline if magnified looks similar to the photo of 1,000 miles of coastline. It is not an exact replica but statistically the proportion of bays and inlets to headlands is the same irrespective of the length of terrain being observed.
Likewise, a price chart for oil showing one minute increments looks similar to a price chart showing daily increments.
Fractals are not only self-similar but they follow a power law.
Something follows a power law if the least frequently occurring elements have the greatest impact and the most frequently occurring elements have the least impact.
An example of a power law is the Pareto Principle, also known as the 80/20 rule, which states roughly 80% of the effects come from 20% of the causes.
Oil, stocks and other securities follow a power law in that the largest contributors to performance occur within concentrated periods of time.
Five years worth of oil price gains can be wiped out in 4 months and most of that price drop can occur within a few days.
Why do security prices behave this way?
Investor psychology. Investors panic and they get exuberant. At times they follow what other investors are doing, assuming other investors know what is going on. That can create an information cascade as many investors abandon their own beliefs and follow the crowd, causing markets to move sharply in one direction as herd behavior takes hold. Prices can just as quickly reverse.
This oil price decline is a classic extreme event as falling prices prompt more selling and more falling prices. Negative sentiment toward oil has not been this high in over 12 years.
At what level will oil prices bottom? No one knows that either.