Relativity, Quantum Mechanics, and the Stock Market

| September 10, 2005

You’re probably wondering what those three things could ever have in common, right? Well, if you know a little something about modern physics, you already understand how general relativity and quantum mechanics are related, but what about the stock market? Einstein and Buffett, together? Come on! What could these two possibly have to talk about? Well… everything, it turns out.

Modern Physics 101

First, a brief, hopefully enlightening discussion of general relativity and quantum mechanics, for those of you who were not fortunate enough to have endured these subjects already as an engineering or physics undergraduate. Fear not, those of you whose eyes are already glazing over: this will not involve any fancy equations or pop quizzes after the discussion! This is simply a primer for the uninitiated, a “Physics For Dummies.” Hey, if we can understand this stuff, anyone can!

Basically, general relativity and quantum mechanics are used to describe and analyze the very large and very small, respectively. If you want to explore the behavior of planets orbitting stars, general relativity provides you with the mathematical tools to do so. However, if you’re interested in tiny paticles such as electrons and protons, quantum mechanics is the way to go. It’s pretty much that simple, at least for the purposes of this discussion. Of course, the more inquisitive readers out there are already wondering why we need two different sets of rules to analyze things in the first place. You’re not alone: physicists everywhere are trying to find a way to unify these two disciplines. If you’d like to delve into the matter further, pick-up a good book on superstring theory. Okay, that’s quite enough digression!

So, general relativity is good at describing the behavior of very big things, and quantum mechanics is good at the very small. But how do very big and very small things behave, anyway? Well–again, for the purposes of this discussion–big things exhibit very orderly, well-defined behavior, while small things tend to be chaotic and unpredictable. For example, a planet’s orbit around a star has a nice, basic geometry to it, while an electron’s path around an atomic nucleus is as far-removed from “orderly” as possible. In fact, at any given moment, it’s literally impossible to determine precisely where the electron is! The best that we can do is make educated guesses based upon probabilities. The point of all this being that “big” things tend to exhibit orderly, predictable patterns, while “small” things are chaotic and unpredictable. Okay, physics lesson over. That wasn’t so bad, now was it?

Physics and Stocks

Some of you no doubt already suspect where this discussion is heading next: the idea that the price movements of securities are governed by similar laws of behavior! Take a look at the following long-term chart of the NASDAQ Composite index:

This chart displays the final phase of the most recent, secular bull market in stocks. As you can see, there is a well-defined, orderly uptrend that ends in 2000, followed by a well-defined, orderly downtrend. And the further you “move away” from the price data–from a time perspective–the more well-defined the trends and patterns become. Now, examine the following intraday chart, also of the NASDAQ:

Notice the chaotic, jerky nature of the price movements, up and down, back and forth. And the “closer in” you move–again, from a time perspective–the more apparently “random” the price movements become.

Okay, at this point, you may or may not be convinced of the validity of the preceding argument. After all, there were certainly some hiccups in that long-term chart, as well as some apparent trends in the short-term one. However, once you understand why the long-term trend is inherently more powerful and predictable than the short-term, the fundamental truth of the idea becomes irrefutable.

Trends and Perspective

Why is price movement more orderly over the long-term than the short? It all has to do with the underlying forces driving the trend. Over long periods of time, fundamentals are in control, in much the same manner that gravity controls the course of very large objects such as planets. However, over the very short-term, fundamentals play a back seat to the highly volatile forces of investor perceptions, emotions, and motivations.

Why does any given investor ultimately decide to buy or sell from moment to moment? Some believe they are doing so objectively, based solely upon their accurate assessment of the fundamentals. However, every investor has human nature to contend with, and our instincts do their best to cloud our judgment. Our decisions are never based upon the fundamentals, but rather on our flawed perception of the fundamentals. Only over the long-term do the true fundamentals reflect themselves in the trend, overcoming the “noise” introduced by our short-term, imperfectly constructed reasonings.

Further, fear and greed creep into our investment decisions more often than we realize, adding significantly to short-term volatility. A stock starts to fall, and fear motivates us to sell before it falls further, regardless of the fundamental reason for the price drop. On the other hand, a rising stock elicits a response from greed, encouraging us to buy more in the hopes of achieving even greater gains. Even those of us who understand and recognize such emotional responses when we feel them are constantly struggling to overcome their effects. The battle to eliminate emotions from the investment decision-making process is one that the vast majority of us lose, and it shows in short-term price movements.

Even beyond our flawed perceptions and irrational drives, the infinite variety in motivations also contributes to the apparent randomness of short-term price fluctuations. Sometimes people simply need or want the money for something (a boat, a house, to pay-off debt, college tuition, etc.), so they sell, and sometimes they buy for an equally diverse set of reasons, none of which can be predicted, and that’s the key to understanding short-term volatility.

While the fundamentals that shape the long-term can be analyzed and understand, chaos theory tells us that no such determinations can be made about short-term price movements. The short-term is, first and foremost, a reflection of human nature in its most imperfect, irrational, and–ultimately–unpredictable form.

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