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Dissecting Why Stock Markets Crash
Who doesn’t love a good stock market crash? Short-term traders aside, it’s an opportunity to recharge your portfolio if you’re a long-term investor and a chance to immerse yourself in the world of Wall Street if you’re a beginner. The lore associated with stock market crashes fascinates almost everyone involved in the investment game, it’s just the case that the fear of a crash paralyzes most traders, in extreme cases keeping them awake at night and afraid to pull the trigger on a transaction. One can get caught up in the drama surrounding a plummeting market, this book attempts to identify the reasons that actually cause markets to fall, through analysis of previous crashes, simulated models and high-tech mathematical equations. While it’s easy to fault the book for being overly technical, I think the author does a great job of explaining the science behind this math and offers solid information that any trader will appreciate.
Didier Sornette begins the book where one would expect any study of stock market crashes to begin, with many of the most famous stock market crashes in history. I found this interesting because there’s always a nugget of information that wasn’t known before when studying the story, like how the South Sea Bubble looked a lot like the schematics of Ponzi lately. It’s a shame it wasn’t published recently, it would have been interesting to see the author’s perspective on the economic collapse of 2008 and the Flash Crash that happened on May 6, 2010. Although when looking at a daily chart of the Dow Jones, the Flash Crash barely registers a blip on the recent economic recovery. If there’s one thing all crashes have in common, they “are caused by the slow buildup of long-term correlations leading to cooperative global market behavior.”
The author pits random walk theory against efficient market theory and I couldn’t discern a clear winner as I sifted through the many complicated graphs and formulas that only a geophysicist like Sornette would truly understand and appreciate. I think you should replace the word random with irrational, because “this rationality is hampered by cognitive biases, emotional whims, and social influences”. Your social network with whom you discuss the markets, be it your friends, family or Twitter colleagues, becomes your tribe and has a great influence on your trading and investment decisions.
One thing I’ve discovered about myself, as I’m a short-term oriented trader, is that I’m one of the “noise” traders needed to provide the liquidity essential for the markets to function properly. of capital. A noise trader as defined by Sornette are “speculators, or traders basing their strategies on technical indicators”.
Simplicity is a key concept when trying to create a model for an early warning collision detection signal. Accidents, by their very nature, are an outlier, meaning a phenomenon that lies outside of everyday experience, and trying to develop a simple system that capitalizes on that. This is what makes them so difficult to predict since they only happen every two decades. It is stock market bubbles that many believe lead to these outliers, but the author dismisses this myth because most bubbles correct themselves.
Since trading is so emotional, this book focuses on many psychological issues such as the disposition effect, which I think most traders can relate to as well. It is passages like the one below that define this effect, that make this book so valuable because it contains many more.
“People value gains and losses relative to a benchmark and tend to seek risk when faced with possible losses, but avoid risk when some gain is possible” and most of traders are “overconfident about their own relative abilities and unreasonably optimistic about their future.” These are a few important concepts that all traders should keep in mind when they are so sure that a trade will go in their favor that they forget to add a stop loss.
While it’s hard to pinpoint which type of trader would enjoy this book the most, I think there’s something for everyone, whether you’re a scenic, technical, or fundamentalist trader. At the time of this print, Didier called the US the biggest bubble of them all, so I’d be very interested to know what they think about the future implications of QE1 and QE2 aftermath. Yes, there are areas of the book that completely went over my head, but for every formula that had a lot of x’s and y’s, there was an important concept that caused me to pick up my pencil to jot down a note so that I may revisit this concept or idea in the future. I feel like I’m smarter after finishing this book and I really enjoyed the long journey and would recommend it to any stock market lover.
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