Just a Random Though

This week a coworker introduced me to a study of the stock market by Benoit Mandelbrot, the famous mathematician who discovered fractals. My coworker, by the way, is a notable mathematician in his own right. Basically Mandelbrot contends there are a lot more large unpredictable moves in stock prices than can be explained by normal statistical means. He contends that because this is so, the investor needs to be far more diversified than previously studies recommend.

In simple terms, there are 50 foot rouge waves that can come unexpectedly out a calm sea. Thankfully, they are exceedingly rare, but that isn’t much comfort if your sailboat happens to be in the path of one of these monstrosities.

What Mandelbrot fails to consider, at least in the brief article I read, is the fact that not all stocks are created equal. If a stock has a high or nonexistent Price Earnings Ratio, an unsustainable dividend, and negative cash flow (GM in the spring of 2008) it is in greater peril than a stable conservative company. Coca Cola (KO) has a realistic Price Earnings Ratio, a sustainable dividend, and good cash flow. KO was certainly damaged in the last year, the worst in 80 but basically it maintained its value.

Of course there are limits to diversification. Index funds, for example, buy the market. At that point the market becomes just another stock and as Mandelbrot observes individual stocks can be hit by unexpected statistical deviations, like a 50% drop in some well managed index funds.

Just some thoughts.

Luke 6

[47] Whosoever cometh to me, and heareth my sayings, and doeth them, I will shew you to whom he is like:
[48] He is like a man which built an house, and digged deep, and laid the foundation on a rock: and when the flood arose, the stream beat vehemently upon that house, and could not shake it: for it was founded upon a rock.
[49] But he that heareth, and doeth not, is like a man that without a foundation built an house upon the earth; against which the stream did beat vehemently, and immediately it fell; and the ruin of that house was great.