December 11, 2018

Why Do Stock Markets Crash?

“Watching how paint dries is not most people’s idea of fun. Nor is watching a sandpile grow, grain by grain. Or is it?

Scientists are not like most people. Some became quite intrigued by what happens to a sandpile as it grows. Their exploration led to break-through insights about stock market risk.

The bottom line: As a sandpile grows, all sort of sand “avalanches” take place, but it is impossible to predict how big or how often they occur. Sometimes a few grains roll down the slope, while occasionally a large avalanche carves a big section of the sandpile. The size and frequency of those avalanches, mathematically speaking, bear a notable resemblance to the size and frequency of earthquakes, solar flares, river floods, forest fires, and stock market returns. Intriguingly, all of them have defied attempts at prediction. The question is why.

One disconcerting aspect is that large avalanches, epic earthquakes or giant forest fires do not seem to be very special: They appear to be just less frequent, scaled-up versions of small ones. If this is true, then a stock market crash may not be special at all, but merely a larger-than-usual down day, and just as unpredictable. This would present a big challenge to traditional investment methods.”

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