The Hindu Business Line : Markets as frictionless and non-linear systems

What are the properties of `frictionless, non-linear systems'? Uh, should we know the answer, you may ask? Possibly, yes, because stock markets are an example of such systems, writes Srinath Srinivasa in The Power Law of Information: Life in a Connected World, from Response Books (www.indiasage.com).

He plots the daily highs from the Dow Jones index for 18 years, from 1985 to 2003, to show one of the interesting characteristics of non-linear frictionless systems, viz. scale variance or self-similarity. This is about how smaller parts of the system share the overall features of the system.

"No matter what block granularity we consider, the average ratio of ups and downs is more or less constant. Whether you look at this dataset week-wise, fortnightly, monthly, yearly or any arbitrary block of consecutive days, the ratio of ups and downs seems to be the same hovering around 1.1," reads a snatch.

Srinivasa mentions how Benoit Mandelbrot had discovered self-similarity `in the behaviour of cotton prices over a period of about 30 years... across two World Wars and the Great Economic Depression of the 1930s.' Another work that finds citation in the book is that of Harold Hurst, who predicted flooding patterns of the Nile, which once seemed to be too erratic to comprehend.

"For centuries, several people had tried predicting the behaviour of the Nile and failed. Hurst studied discharge patterns from the Nile and several other rivers and lakes around the world and observed that flood or drought patterns tend to display similarities across different granularity levels."

The Web is again an example of self-similarity, like the markets, says the author. "Web pages display a power law distribution on the number of their incoming links. That is, a few Web pages have a large number of other Web pages pointing to them, while a large number of pages have very few other pages pointing to them." Power law, in simple, denotes "a system with a very small number of extremely powerful entities and a very large number of entities having very limited power." No different from Pareto 80-20 law.

Frictionless systems have extremely low transaction costs, describes Srinivasa. "Any event in the system is likely to cause a large number of transactions."

And non-linearity means that `events and their repercussions are so finely intertwined that it is often impossible to ascertain what is cause and what is effect'. Quite true of the bourses, you'd agree.

Exploit for profit

In a section on properties of information, one learns how information such as stock prices, news and weather reports can be a consumable. These can be `exploited for profit.' The survival of a business may be dependent on what amount of consumable information is present in their data. "A television news channel dishing out stale news the entire day is less likely to be more popular than the one that can bring the latest and breaking news."

Information can be reusable, as in the case of a technical paper, or a music CD. "Reusability of information is exploited in business models that charge users per use." Information can be a service, as for example a data aggregation; here, the measure of quality depends on `how comprehensively it has anticipated external conditions and is able to negotiate them'. Lastly, information can serve as a control device, such as, deciding on when to exit a scrip.

All information does not necessarily cascade across the system, he writes in a chapter on information networks.

"Few, if any, have ever cascaded at such a vast scale and at such a speed like the milk-drinking Ganesha phenomenon." At a lower scale, perhaps, are panic selling and frantic buying. How fast an idea spreads depends on `the threshold for accepting a new idea.'

For instance, if the threshold is 50 per cent, "a person accepts a new idea if at least half of his/her neighbours have adopted the new idea."

Social networks that are too densely connected act as inertia to the propagation of new ideas, says Srinivasa. How so?

"They implicitly bring pressure on the population to conform or maintain the status quo." Does that possibly explain why the majority of those who play the stock markets lose out?

Power read!

Of value can be ESS or `evolutionary stable strategy,' which helps one to remain in existence, regardless of how the evolutionary forces behave. With such a strategy, say, to manage your finances, you may never be the richest person in your circle; "however, when aggregated over a lifetime, the person with the ESS would have had the least number of financial crises." The best tool to find ESS is simulation, opines Srinivasa.

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