• Dec. 9, 2016, 1:44 am

Of broccoli and fractals

Blue Elephant Capital Management’s Brian Weinstein always has something interesting to say about the world of investing. This month he compares broccoli and fractals.

 

Writing something new and (hopefully) interesting every month isn’t easy. I’ve been lucky in some ways the last few months that there have been some obvious topics worth exploring.

It is our philosophy at Blue Elephant that we help investors understand the lending landscape. Since loans aren’t something most investors are familiar with, writing about how loans are underwritten, how the business cycle impacts our allocation, and what information can be gleaned from loan performance are topics that are important for us to discuss. Having covered these exhaustively over the last few months, I found myself searching for a topic that our investors and readers (future investors!) would enjoy and quite honestly was drawing a blank. Last weekend we had dinner with some friends who somehow ended up introducing me to a bizarre source of inspiration – Romanesco broccoli.

Very simply, I’m not the world’s biggest broccoli fan. I blame this primarily on the fact that it doesn’t taste good and secondly on my mother, who by my recollection, made me eat it seven nights a week.

I had never heard of Romanesco broccoli, so I did what any good broccoli skeptic would and googled it. I learned that it has a more “delicate and nutty” flavor, which isn’t terribly relevant to investing but made me hopeful that there could be a better-tasting broccoli alternative out there.

More relevant and inspiring is the way it looks. It is a fractal. According to Wikipedia, “A fractal is a natural phenomenon or a mathematical set that exhibits a repeating pattern that displays at every scale.” In other words, if you zoom in on each bud of the broccoli, the pattern you see in this picture would be replicated over and over again.

Fractals play an interesting role in financial markets. Investors like to think about returns linearly – prices go up and down over time, generally following a bell-curve shaped distribution.

Every once in while we get an event to the upside like the tech bubble of the late 1990’s or to the downside like in the “great recession” of 2008. These events are often explained away as unlikely or aberrations blamed on outside forces.

While this may help us sleep better, fractal theory suggests that “outlier” events happen all the time in markets, both to the upside and the downside. The (Mis)Behavior of Markets by Mandelbrot & Hudson sums up the shortcomings of bell curve theory statistically. Looking at data from 1913 to 2003 they write, “Theory suggests that over that time, there should be fifty-eight days when the Dow Jones moved more than 3.4 percent; in fact, there were 1,001… And index swings of more than 7 percent should come once every 300,000 years; in fact, the twentieth century saw forty-eight such days.”

Without getting more technical, fractal theory tells us that markets are much more volatile than we’ve generally been led to believe. Patterns are likely to repeat themselves, and we should be careful to dismiss market volatility as a rarity. Instead, we should approach investing knowing full well that we should, as Scientific American writes in “How Fractals Can Explain What’s Wrong with Wall Street”, “recognize the mariner’s warning that, as recent events demonstrate, deserves to be heeded: On even the calmest sea, a gale may be just over the horizon.”

Much like broccoli itself, this message sounds a little tough to swallow. It sounds like we should be afraid of investing – but that isn’t the point at all. Instead, I think it highlights both the predicable cyclicality and unpredictable volatility that every investor lives with. If, instead of being scared by volatility, we accept it as part of the very fabric of investing, we will make decisions that help us avoid some of the negative outcomes.

We get a lot of questions about the “unknowns” surrounding marketplace lending. Lending is one of the oldest businesses in the world – technology is providing a new interface that helps borrowers and lenders interact. The data that lenders are using is available to us before we make the decision to invest, which is something that is not true about many other asset classes.

This isn’t to suggest that marketplace lending is without risk. I would suggest, however, that our investors are being well compensated for taking risk through high yields, even after adjusting for defaults. If the liquid markets are more volatile than generally assumed, investors might be better off in the higher yielding “unknown” than in more traditional vehicles.

It also makes sense to invest with a manager such as Blue Elephant that has experience dealing with market cycles – we make our decisions knowing that a large part of the battle is avoiding large drawdown scenarios. You can call it being conservative, but we’d call it a smart way to approach the unknowns of marketplace lending.

I do eat regular old green broccoli at least once a week, mostly to mitigate risk. Eating healthy means I can hopefully live longer, which will allow me to do more of the things that I enjoy. I doubt that Romanesco broccoli will change my opinion on the vegetable broadly, but I guess I won’t know until I try.

Some people actually love the taste of broccoli. Similarly, maybe marketplace lending is for you, or maybe you are more comfortable in traditional markets. As we say in finance, that’s what makes a market.

Happy investing,
Brian Weinstein

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