What is 'Chaos Theory'

Chaos theory is a mathematical concept that explains that it is possible to get random results from normal equations. The main precept behind this theory is the underlying notion of small occurrences significantly affecting the outcomes of seemingly unrelated events.Â Chaos theory is alsoÂ referred to as "non-linear dynamics."

Next Up

BREAKING DOWN 'Chaos Theory'

Chaos theory has been applied to many different things, from predicting weather patterns to the stock market. Simply put, chaos theory is an attempt to see and understand the underlying order of complex systems that may appear to be without order at first glance.

Chaos theory is highly controversial and extremely complicated.Â Related to financial markets, proponents of chaos theory believe that price is the very last thing to change for a stock, bond, or some other security. Price changes can be determined through stringent mathematical equations predicting the following factors:

1.Â A trader's own personal motives, needs, desires, hopes, fears and beliefs are complex and nonlinear.
2.Â Volume changes
3.Â Acceleration of the changes
4.Â Momentum behind the changes

Core Factors BehindÂ Chaos Theory

• The Butterfly Effect: According to the Butterfly Effect, a butterflyÂ in CaliforniaÂ canÂ cause a hurricane in China materialize ifÂ the butterfly flapsÂ its wings at just the right point in space andÂ time. While the result isn't immediate,Â the causal connection is real. The hurricane would not have happened if not for the butterfly. Expressed more generically, small changes inÂ initial conditions can lead to drastic changes in finalÂ results. Human civilization is anÂ ongoing demonstration of this principle in action. Who knows, for instance, what the long-term effects of teaching millions of people about chaos theory will be?
• Unpredictability: Because all theÂ initial conditions of a complex system are not fully knowable, it is impossible to predictÂ theÂ fate of a complex system. Even if all the conditions can be measured,Â slight errors in measurements will beÂ amplified dramatically, rendering any prediction useless. This is whyÂ accurate long-range weather prediction will always remain impossible.
• Order / Disorder: Chaos is not simply disorder. Chaos comprises theÂ transitions between order and disorder, which often occur in surprising ways.
• Mixing: Turbulence ensures that, in time, two adjacent points in a complex system will eventually end up in very different positions. For example, two neighboring water molecules may end up in different parts of the ocean or even in different oceans. A group of helium balloons that launch together will eventually land in drastically different places. Mixing is thorough because turbulence is non-linear andÂ happens at all scales.
RELATED TERMS
1. Accelerator Theory

The accelerator theory is an economic theory whereby as demand ...
2. Time-Preference Theory Of Interest

The time preference theory of interest explains interest rates ...
3. Decision Theory

Decision theory is an interdisciplinary approach to determine ...
4. Expectations Theory

The hypothesis that long-term interest rates contain a prediction ...
5. Market Segmentation Theory

A modern theory pertaining to interest rates stipulating that ...
6. Residual Equity Theory

Residual equity theory assumes common shareholders to be the ...
Related Articles
1. Investing

Modern Portfolio Theory Vs. Behavioral Finance

Or: How financial markets would work in an ideal world vs. how they work in the real world.
2. Investing

Interest Rate Predictions With Expectations Theory

The expectations theory uses long-term interest rates to predict future short-term interest rates.
3. Investing

Redefining Investor Risk

Changing the way you think about time and risk can change the way you invest.
4. Investing

Nobel Winners Are Economic Prizes

Before you try to profit from their theories, you should learn about the creators themselves.
5. Investing

Oil As An Asset: Hotelling's Theory On Price

Not sure where oil prices are headed? This theory provides some insight.
6. Investing

Arbitrage Pricing Theory: It's Not Just Fancy Math

What are the main ideas behind arbitrage pricing theory? Find out how this model estimates the expected returns of a well-diversified portfolio.
RELATED FAQS
1. What is the chaos theory?

The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>

3. What are the differences between weak, strong and semi-strong versions of the Efficient ...

Discover how the efficient market theory is broken down into three versions, the hallmarks of each and the anomalies that ... Read Answer >>
4. How does money supply affect inflation?

Learn about two competing economic theories of the role of the money supply and whether money supply causes inflation in ... Read Answer >>
5. Why is game theory useful in business?

The concepts of game theory became a revolutionary interdisciplinary phenomenon, but they are still relevant for business ... Read Answer >>
Hot Definitions
1. Leverage

Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
2. Financial Risk

Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
3. Enterprise Value (EV)

Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
4. Relative Strength Index - RSI

Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
5. Dividend

A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
6. Inventory Turnover

Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.