Stock Market as a Complex Adaptive System

The most often heard and most ‘text-bookish’ definition of the stock market is that it is a platform to buy and sell shares and related securities. In a way, it’s a good definition and captures the basic nature of the stock market. But I would say it’s too simplistic.

And, taking inspiration from Complex Adaptive System (CAS) theory related to physics, I would define the stock market also as a CAS. One major reason is that like any complex adaptive system, small changes in the actions of the multitude of interacting participants can create highly unpredictable movements in the system and can altogether change the system, making it difficult to find patterns and predict ‘system’ movements – read ‘stock market movements.’ This is precisely why consistently predicting stock market movements is almost impossible.

When we view from a complex adaptive systems approach, we can understand why stock market returns are inherently non-linear. The problem with most investors is that they naturally understand positive linearity and apply the same to understand the stock market. They expect positive linear returns from the stock market, consistently. But in fact, stock market returns are mostly non-linear: for example, a stock can show no material movement for many years and suddenly in a matter of weeks or months, it can double or triple. In this non-linear nature, it almost mimics our life in general. Once you understand this, coping up with the volatility of the stock market becomes easier.

The collective behaviors of stock market participants and their reflexive interactions decide stock prices and how the stock market as a whole move. As its fundamental natures are “collective behavior” and “complex interactions” there is no rationality in the stock market. So the idea that all information is already reflected in stock prices and the market is efficient is inherently invalid. The fact is, when it comes to the stock market, an information asymmetry exists even in this ‘information age.’ And, the way stock market participants process and act upon the same publicly available information vastly differs too.

In essence, all investors should understand two most important things. First, it is futile to predict stock market movements or individual stock prices. Rather, they should try to understand inherent valuation asymmetries and try to profit from it. Second, they should be comfortable with non-linear returns. This is extremely important for profiting from stock market investments in the long term.

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