Fractal Markets Hypothesis (FMH)

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DEFINITION of 'Fractal Markets Hypothesis (FMH)'

An alternative investment theory to the widely utilized Efficient Market Hypothesis (EMH), Fractal Market Hypothesis (FMH) analyzes the daily randomness of the market and the turbulence witnessed during crashes and crises. The framework of the Fractal Market Hypothesis proposes a clear explanation of investor behavior throughout a market cycle, including booms and busts. Major components of the theory focus on the investment horizons and liquidity of markets given a certain amount of information. The market is considered stable when it is comprised of investors of different investment horizons given the same information. Conversely, leading into crashes and crisis, FMH asserts that investment strategies converge to shorter time horizons. As a result, markets become less liquid and more inefficient.

BREAKING DOWN 'Fractal Markets Hypothesis (FMH)'

Falling into the framework of chaos theory, FMH explains markets using the concept of fractals. Fractals are fragmented geometric shapes that can be broken down into parts which replicate the shape of the whole. With respect to markets, one can see that stock prices move in fractals. Due to this characteristic, technical analysis is possible: in the same way that the patterns of fractals repeat themselves along all time frames, stock prices also appear to move in replicating geometric patterns through time.

The study of investment theories relies heavily on the actions of investors given certain information. In stable times, information does not dictate investment horizons and market prices. There are various numbers of long term investors who balance the numbers of short term investors. However in bearish markets, investors trend towards short term horizons, reacting to price movements and information. As a result, the market becomes unstable and inefficient. Unlike EMH, Fractal Market Hypothesis clearly defines investor behaviors in all market conditions.