Equity Analysis in a Complex Market
Abstract: Investment approaches are determined by investors’ views of the market. For investors who believe the market is basically efficient, so that price changes are essentially random and unpredictable, the reasonable approach is passive investing, or indexing, which makes no attempt to outperform the underlying market. Investors who believe there are clear-cut patterns discernible in stock price movements may aim for above-market returns by using fairly simple approaches, such as buying stocks with low price/earning ratios or buying small-capitalization stocks. But what if the market is not totally efficient, but there are no simple patterns that can be exploited for consistent excess returns? Such a complex market requires an investment approach capable of dealing with that complexity.
Scientists classify systems into three types— ordered, random, and complex. Ordered systems, such as the structure of diamond crystals or the dynamics of pendulums, are definable and predictable by relatively simple rules and can be modeled using a relatively small number of variables. Random systems like the Brownian motion of gas molecules or white noise (static) are unordered; they are the product of a large number of variables. Their behavior cannot be modeled and is inherently unpredictable.
Complex systems like the weather ...