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. Chaos theory is also referred to as "non-linear dynamics."

Understanding 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.

The first real experiment in chaos theory was done in 1960 by a meteorologist, Edward Lorenz. He was working with a system of equations to predict what the weather would likely be. In 1961, he wanted to recreate a past weather sequence, but he began the sequence midway and printed out only the first three decimal places instead of the full six. This radically changed the sequence, which could reasonably be assumed to closely mirror the original sequence with only the slight change of three decimal places. However, Lorenz proved that seemingly insignificant factors can have a huge effect on the overall outcome. Chaos theory explores the effects of small occurrences dramatically affecting the outcomes of seemingly unrelated events.

Chaos Theory in the Stock Market

Chaos theory is a controversial and complicated theory that has been used to explain some features of systems that have traditionally been difficult to accurately model. The financial markets fall into this category with the additional benefit of coming with a rich set of historical data. One interesting financial phenomenon that chaos theory can help illustrate, if not explain, is how seemingly healthy financial markets can suffer sudden shocks and crashes.

Proponents of chaos theory believe that price is the very last thing to change for a stock, bond or other security. This suggests that periods of low price volatility do not necessarily reflect the true health of the market. Looking at price as a lagging indicator puts investors in the dark as far as being able to spot crashes before they happen. This does, of course, fit the experience of most investors who have experienced black swan events and financial meltdowns. There are some who seem to be able to position themselves for market downturns in advance, but they are often digging much deeper than price data to understand structural weaknesses that most of the market has overlooked.

The big caveat with chaos theory is that it is too often used as a way to discount investing. While the markets are almost impossible to predict over a short-term period, they are more consistent over the long-run. Just because you can't time the next crash doesn't mean you shouldn't be investing in stocks with strong fundamentals that tend to perform over the long-term.