We, humans, love predictability, and we love to theorize and identify patterns even in entirely random situations. However, certain things in this world cannot be theorized or estimated. This uncertainty has led to what is known as The Chaos Theory or The Butterfly Effect. The main premise of this theory is that everything is unpredictable in life, and even a small event can lead to a big boom. This effect has been seen numerous times before in history.
This theory was discovered by Professor Edward Lorenz, who studied how even small changes could have a drastic effect on the final result. In 1961, he studied how entering one initial value as 0.506 instead of 0.506127 in a weather model, led to a very different result. This theory explains that a butterfly flapping its wings in one corner of the world could cause a hurricane in a completely different part of the world. This theory is not only applicable to natural disasters and weather conditions, but it can also be applied to financial markets and economic conditions.
Butterfly Effect in the Financial World
With Globalisation and Liberalisation, and the advent of technology, countries all over the world are susceptible to what is happening around them. This connectivity and dependability would mean that a small bump in the markets of one country could cause drastic consequences in other parts of the world. For instance, the fall of the Lehman Brothers in the United States in 2007-2008, led to the collapse of economies worldwide and caused The Great Recession.
The stock markets of many countries suffered majorly; unemployment rates rise to high levels, and the growth of some major developed economies became negative. It took the world around two years to recover from this recession. We can also see this in the case of the current coronavirus pandemic. The virus that started in Wuhan, China, rapidly spread to other parts of the world and brought all the world economies to their knees. This is no more a health-care crisis only, but it has also turned into a financial and economic crisis.
This Butterfly Effect, however, does not always have to be a bad thing. Small things done carefully can lead to big positive impacts as well. Looking at it from a financial perspective, good saving habits and careful investing, practiced over the long run, can result in big gains in one's portfolio. Small savings and investments can lead to a compounding effect. It is one of the principles of the famous investor, Warren Buffet. By saving this way, investors would be able to satisfy their different financial and primary goals and could maybe even fund their aspirational goals.
Examples of Butterfly Effect in Financial Markets
One major example of the Butterfly Effect in the field of finance would be the day of 19th October 1987, which came to be popularly known as Black Monday. On this day, stock markets around the world crashed, and this crash started in Hong Kong and then quickly spread to other parts of the world as well.
It had a severe impact on the U.S. stock market, and it is on this day that the Dow Jones Industrial Average (DJIA) lost around 22%. This has been one of the largest percentages of falls ever for the U.S. stock market. There was no specific explainable cause for this crash, and many analysts believe that it could be a result of fundamental mistakes in the trading software, which caused this crash.
Another instance that had a major impact on other economies, even the Indian stock market, is the 2015 volatility in the Chinese stock market. China's stock market dropped by 8% in a single day, and the ripples of this were felt in other markets too. The S&P 500 and Nikkei both lost around 4%. Similar to the Black Monday, experts could not specify a single reason for this downfall.
An example of the Butterfly Effect in India would be the IL&FS crisis. This was caused by the non-performing assets (NPAs) decreasing in value and IL&FS facing a huge debt and liquidity crunch. This further resulted in a major liquidity crisis in India and resulted in other NBFCs defaulting. This had a cascading effect on the banking industry as a whole and other sectors like the automobile sector, the real estate sector, etc.
We can also see this in the case of Maruti Suzuki in India. Maruti is a company that has been hugely profitable for investors who have held on to its shares for a long period of time. The share price of this company, which was around Rs. 1500 at the start of 2010, has now increased to around Rs. 6000. That is a growth of 300%. In all these years, the company had to stop its production once and even faced supply issues from its ancillaries; still, the company managed to remain strong. So, a small investment in the company during the initial years would have resulted in huge turnovers.
Another company would be Infosys. This company had a range of Rs. 150 during the year 2000, and now if we look at its share price, it has crossed Rs. 800 and is in the range of 830-850. That is a growth rate of more than 400%.These were some of the examples of the Butterfly Effect in both India and across the world.
What should Investors Do in Butterfly Effect?
We can agree that the Butterfly Effect could have a bad impact as well as a good impact. However, in the stock market, investors cannot predict any event and decide where it would go. The magnitude also cannot be predicted accurately. So, investors need to be careful and take certain precautions to safeguard themselves against any losses.
One of the ways of doing that would be to diversify our investment portfolio. We should be smart enough not to put all our funds and risk everything into a single bucket. We should invest in the sectors and securities in such a way that they are not co-dependent or correlated. So that if one sector performs badly, the other remains steady and we are hedged that way. Hence, we should take the advice of our financial advisors and perform due diligence in order to diversify our risks away.
The other way of saving ourselves from such uncertainties would be one that we have mentioned already. This emphasizes the need to control our expenses and save some of it so that we can invest it. These small savings can go a long way. Later, in times of uncertainties, investors can fall back on these savings. So, investors should regulate and monitor their expenses and savings carefully and on a regular basis.
It has been rightly saying that prevention is better than cure. So, investors need to be cautious while investing in the stock market because it is quite evident that the markets cannot be controlled. The amount of risks that an investor takes needs to be decided with proper planning and after taking into all types of scenarios, even accounting for the ones that cannot be predicted.