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Mandelbrot Portfolio Theory
Modern portfolio theory is based upon diversification as a risk-mitigation strategy. It combines multiple assets based on different risk exposure. The problem with such a practice is that it may not reduce risk at all.
Benoit Mandelbrot, the French Mathematician famous for fractals, used his findings to study financial markets. Actually drawing similarities between the natural world and economics. “A very large part of economic theory is just physical theory with the words changed,” he concluded.
The largest contribution Mandelbrot brought to economics was the idea that prices can be discontinuous. Meaning that prices can teleport randomly from one value to another without any gradual transition. A similar phenomenon to coastline geometry.
His discovery debunked using the random walk method as an accurate measure of portfolio risk. The random walk assumes that the price at any given moment depends on what it was the moment before. Something that is clearly false.
Instead, Mandelbrot proposes that economics is dominated by extreme cases. Those outliers that come from nowhere destroy earnings and sometimes even lives. Consider the 1986 stock-market crash, Enron, and the 2008 housing bubble, just to name a few.
