Wouldn't planning be easy if we could see what was coming next? In the investment industry, much has been written about predicting investment returns and the future in general. Right now, you may be thinking, the consensus opinion says future prices can't be predicted and persistent alpha is statistical luck-not the result of skill. So why bother looking ahead? In my May 2009 column I mentioned examining what other disciplines are doing to peer into the future. This column discusses promising research into complex systems and insuring against volatility bubbles.

COMPLEX SYSTEMS

In my column, I referred to "complex systems" as discussed by Eric Beinhocker in The Origin of Wealth. A complex system is an organized system composed of interconnected parts, which as a whole exhibit one or more properties (behavior among the possible properties) that are not obvious from the properties of the individual parts. Examples are animal colonies, human economies, plate tectonics, weather, nervous systems and energy and communication infrastructures. Much of what will impact our clients is the result of complex systems such as the global economy, capital markets and politics.

Why is the analysis of these systems important to planners? One problem with complex systems is the difficulty with modeling and simulation, which presents a challenge and an opportunity. Take the equity markets, for example. Professionals have engaged in a huge amount of research and modeling in their efforts to predict future equity prices, based on equilibrium models, fundamental research, technical trend analysis and so forth. Nothing so far has worked consistently or well.

The problem is, individual equity prices are a lot like blood pressure readings. Both are manifestations-called an emergent property-of an entire system's interactions, whether that system is the global equity markets or the human body. There's more than one thing causing the emergent property. However, with today's supercomputers, modeling a system's emergent properties can unlock how systems create those changes-and give us clues to what's next.

FORECASTING CRITICAL EVENTS

One scientist studying emergent properties, such as critical events or bubbles (extreme up or down volatility), in markets right now is Didier Sornette, a geophysicist with the Federal Institute of Technology in Zurich, Switzerland. In various books and papers, Sornette explains his model, which combines economic theory, behavioral finance, and mathematical and statistical physics (the math is daunting).

For instance, Sornette's log periodic power law (LPPL) model considers a faster-than-exponential increase in asset prices, highlighted by accelerating oscillations, as the main precursor of bubbles. It incorporates a positive feedback loop of anticipated higher returns against a negative feedback loop of expected crashes.

Sornette's models predicted the peak of the oil price bubble in early July 2008 and the burst of a bubble on the Shanghai stock market in early August 2009. Sornette has also used variations of this model to predict rebounds from market crashes.

Will it continue to work? Currently, he is conducting something called the Financial Bubble Experiment. Sornette's research team identified seven bubbles in seven different global assets; for four of these assets, he presented windows of dates for the most likely ending time of each bubble to an independent organization, which is safeguarding that information to avoid speculation. Documentation of the original analysis was released on Nov. 1, 2010, after this magazine went to press (see www.er.ethz.ch/publications/finance/bubbles_empirical for more details).

THE UNCERTAINTIES OF LIFE

Recently I had dinner with Robert Merton, a Nobel Laureate in economics. He expressed concern over hypertrading: buying and selling the same security in a matter of milliseconds (aka high-frequency trading). He contended that although hypertrading adds liquidity to the markets, it may also distort the rational equilibrium price of the security.

Sornette's conclusion about the market balance between hypertraders, which he humorously calls furious alpha-seeking traders (FAST) and steady buy-and-hold investors (SBAH), is more telling. If the FAST are balanced by the SBAH, only when emotions sway more of the SBAH does the market reach a critical point. On the other hand, if the FAST outnumber the SBAH, critical events are more frequent and more extreme.

Public exchanges like the NYSE or NASDAQ have circuit breakers that slow or halt trading when price changes exceed certain parameters. However, according to some researchers, with large "dark pools" of capital now operating outside these traditional markets, the imbalances Sornette talks about are much more likely to occur, resulting in much greater volatility in our future. Recognizing a price tsunami before it hits could be very valuable-if we can move out of its way or insure against a loss.