Fundamentals Of Fractal Markets Theory

In the wake of the 2008 financial crisis, many have challenged the dominant economic theories and perspectives on markets. The Efficient Market Hypothesis (EMH) in particular has fallen short in explaining the crisis. According to the EMH, given rational expectations from investors and market efficiency, an investor is unable to beat the market and gain consistent returns. Furthermore, investors are unable to either purchase undervalued or sell undervalued stocks.  In order to achieve returns in excess of average market returns, investors must bear the risks associated with volatile assets.

On the other hand, renowned economist Robert Shiller insists assets prices are inherently volatile and thus the assumption of market efficiency and rational expectations cannot be made. While EMH still resides at the forefront of modern financial theory, alternative theories that provide a more accurate representation of markets have emerged. Fractal Market Hypothesis, for instance, focuses on the investment horizons and liquidity of markets and investors – factors limited in the framework of EMH. The theoretical framework of fractal markets can clearly explain investor behavior during periods of crisis and stability. (For more, see: Financial Concepts: Efficient Market Hypothesis.)

Edgar Peters formalized FMH in 1991 within the framework of chaos theory in 1991 to explain the heterogeneity of investors with respect to their investment horizons. The concept of fractals comes from mathematics and refers to a fragmented geometric shape that can be broken into smaller parts that fully or nearly replicate the whole. 

Intuitively, technical analysis falls within the context of fractals: the foundation of technical analysis focuses on the price movements of assets under the belief that history repeats itself. Following this framework, FMH analyzes investor horizons, the role of liquidity, and the impact of information through a full business cycle. (For more, see: Basics Of Technical Analysis.)

An investment horizon is defined as the length of time that an investor expects to hold assets or securities. Investment horizons can effectively represent investor’s needs such as degree of risk exposure and desired return on investments. Within the context of FMH, investment horizons during stable periods tend to balance between short-term and long-term.

Short-term investors will place greater value on the daily highs and lows of an asset compared to long-term investors. However, when a crisis occurs or is forthcoming, FMH states one investment horizon will dominate the other. Prior to and during a crisis, short-term trading activity tends to increase more than long-term. Typically, long-term investors shorten their investment horizons as prices continue to fall as observed in a financial crisis. When investors change their investment horizons this causes the market to become less liquid and unstable.

Liquidity is referred to as market liquidity in the FMH. Market liquidity is the ease with which an investor is able to buy and sell securities without their actions affecting market prices. Liquidity is generated whenever investors trade with each other, thus two investors must hold different views on the value of assets and securities. In times of crisis, the hypothesis states that long-term horizons are reduced; consequently, liquidity dissipates as investors homogenize, and no one is willing to take the other side of a trade. Under fractal structures, differing interpretations of information result in varying time horizons ensuring market liquidity and orderly price movements. (For more, see: Understanding Financial Liquidity.)

The role of information is crucial in making sound decisions with any sort of investment strategy. Within the framework of FMH, the impact of information availability can lead to changes in time horizons and liquidity. During times of stability, FMH states all investors share the same information. How information is perceived results in the individual investment decisions: a day trader may perceive price fluctuations and decide to sell, while a pension fund manager will place less value on price movements.

However, if investors witness extreme declines in prices from a previous period, long-term investors may be inclined to reduce time horizons and begin to sell. As a result, a decline in prices from a previous period can cause further price to declines in the current period. As stated in FMH, information that causes investment horizons to change will result in market instability and illiquidity.

In analyzing financial theory, the Efficient Market Hypothesis has dominated and continues to dominate the economic literature. EMH asserts market efficiency with investors acting rationally. However, under this framework, phenomena such as crises cannot be explained.  Proponents of EMH suggest irrationality amongst investors as a factor when explaining the 2008 Financial Crisis and housing bubble. However, by definition, financial markets disperse all available information efficiently, which is reflected in market prices and rationally acting investors.

Failing to acknowledge market inefficiencies gives credence to alternative theories of markets, including the Noisy Market Hypothesis, Adaptive Market Hypothesis, and Fractal Market Hypothesis. Unlike EMH, FMH analyzes the behavior of investment horizons, the role of liquidity, and the impact of information during crises and stable markets. Within the framework of FMH, stable markets result in highly liquid assets. Referred to as market liquidity, liquidity is created when investors are able to trade with each other as a result of investors holding different investment horizons.

Stability under FMH requires a variety of different investment horizons and liquid assets. When information dictates buying and selling, instability occurs. In times of crisis, investment horizons shorten, resulting in a greater number of investors selling illiquid assets. While fundamentally different from EMH, both market theories predominantly rely on the impact of information to understand investor behavior.