2/28/2007 – Look to a Sand Pile to Explain the Market’s 3% Decline

It is human nature to want to “explain” why the stock market declined by 3% yesterday. There will be many legitimate reasons given by market pundits but a conclusive explanation will prove elusive.

To understand why we can turn to physicist Per Bak who used sand piles to explain about complex adaptive systems found in nature. Fortunately, the analogy is useful when thinking about stock market behavior. If you build a sand pile one grain at a time, at first the pile is stable. As the pile grows and becomes steeper, additional grains will sometimes cause a sand slide. In fact, Bak and his associates did this millions of times through the use of a computer program. They found that most of the time the sand slides were little, but sometimes they were big, and although rare, occasionally the sand slide wiped out the pile. 

In the case of the large sand slide something as inconsequential as a grain of sand caused a disproportionate outcome (the pile was wiped out). The parallel for investors is that many times big moves in the stock market are caused by grains of sand that are impossible to identify. Why did the market decline by 3% instead of 0.5%? Nobody knows for sure; it just happened. 

What we can say with some confidence is that increased volatility if here to stay. The history of the stock market clearly reveals that volatility clusters: so fasten your seatbelts!