Model Says Go With Flow Of The Market Laws Of Physics Unkind To Stock Pickers, Favor Bonds

Two Boston physicists, one of whom admits he’s never invested in the stock market, recently looked at the ups and downs of trading and saw a pattern: Being in the market is like being a cork tossed about in a churning, treacherous river.

Rosario Mantegna and Eugene Stanley of Boston University used the mathematical tools of physics to describe market fluctuations, in part, because they had heard that other scientists were using the “chaos theory” to examine Wall Street.

You can’t predict individual stocks any better than you can predict the motion of individual waves in a river, says Stanley.

But you can use this model to measure the risk of jumping in - or investing. That, he says, is the significance of the finding, which is published in the currents issue of the scientific journal Nature.

While many mathematical formulas have been devised to describe the stock market, this one does say something new, according to economist Alan Timmermann, of the University of California, San Diego. “You have a higher probability of large shocks,” with the physicists’ model, including a few precipitous drops such as the crash of 1987.

Stanley says he’s never invested in the market, but he got interested when he read that other physicists had been trying to apply chaos theory to stock behavior.

He doesn’t believe the chaos theorists have shed much light on the market’s predictability. His evidence: “None of them have made any money.”

So Mantegna and Stanley applied their own statistical analysis to the stocks in the Standard & Poor’s 500, widely used as a barometer of the market.

“That part was really very simple,” he says.

He and Mantegna read a computer tape that tracked the fluctuations of S&P 500 every 15 seconds for a period of six years, giving them a total of a million and a half data points.

To analyze that mass of numbers, they first recorded the size of each tic, then sorted the ups and downs by size.

The “distribution” plot they made showed the number of sticks of each length - which corresponds to the number of jumps of each size in the market. Most of them were short, a few medium, and a fewer still, long.

If the market fluctuated randomly, they would have seen a “standard distribution,” characterized by a bell-shaped curve.

They saw something different. “I recognized it right away” says Stanley. In physics jargon, it was a Levy walk - a pattern that describes the way particles move around in turbulent fluids. Corks floating in rough water would follow such a pattern.

Economist Timmermann says he thinks the turbulent water analogy gives people a realistic view of the risks of investing in stocks. “Maybe some people will start investing less in stocks, and more in safer bonds,” he says.

This model is bad news for anyone who wants to predict when individual changes will happen, says Stanley.

“No one will ever be able to do that,” he says. “If we could do that, we’d be very rich.”