Seven states of randomness

The seven states of randomness in probability

theory, fractals and risk analysis are extensions
of the concept of randomness as modeled by
the normal distribution. These seven states
were first introduced by Benoît Mandelbrot in
his 1997 book Fractals and Scaling in
Finance, which applied fractal analysis to the
study of risk and randomness.[1] This
classification builds upon the three main states
of randomness: mild, slow, and wild.

The importance of seven states of

randomness classification for mathematical
finance is that methods such as Markowitz
mean variance portfolio and Black–Scholes Stochastic process with random increments from a
model may be invalidated as the tails of the symmetric stable distribution with α = 1.7. Notice the
distribution of returns are fattened: the former discontinuous changes.
relies on finite standard deviation (volatility)
and stability of correlation, while the latter is
constructed upon Brownian motion.

History
These seven states build on earlier work of
Mandelbrot in 1963: "The variations of certain
speculative prices" [2] and "New methods in
statistical economics" [3] in which he argued
that most statistical models approached only a
first stage of dealing with indeterminism in
science, and that they ignored many aspects of
real world turbulence, in particular, most cases
of financial modeling.[4][5] This was then
Stochastic process with random increments from a
presented by Mandelbrot in the International
standard normal distribution.
Congress for Logic (1964) in an address titled
"The Epistemology of Chance in Certain
Newer Sciences"[6]

Intuitively speaking, Mandelbrot argued[6] that the traditional normal distribution does not properly capture
empirical and "real world" distributions and there are other forms of randomness that can be used to model
extreme changes in risk and randomness. He observed that randomness can become quite "wild" if the
requirements regarding finite mean and variance are abandoned. Wild randomness corresponds to situations
in which a single observation, or a particular outcome can impact the total in a very disproportionate way.
The classification was formally introduced in his 1997 book
Fractals and Scaling in Finance,[1] as a way to bring insight into
the three main states of randomness: mild, slow, and wild . Given N
addends, portioning concerns the relative contribution of the
addends to their sum. By even portioning, Mandelbrot meant that
the addends were of same order of magnitude, otherwise he
considered the portioning to be concentrated. Given the moment of
order q of a random variable, Mandelbrot called the root of degree q
of such moment the scale factor (of order q).
Random draws from an exponential
The seven states are: distribution with mean = 1.
(Borderline mild randomness)
1. Proper mild randomness: short-run portioning is even for
N = 2, e.g. the normal distribution
2. Borderline mild randomness: short-run portioning is
concentrated for N = 2, but eventually becomes even as
N grows, e.g. the exponential distribution with rate λ = 1
(and so with expected value 1/λ = 1)
3. Slow randomness with finite delocalized moments: scale
factor increases faster than q but no faster than , w < 1
4. Slow randomness with finite and localized moments:
scale factor increases faster than any power of q, but
remains finite, e.g. the lognormal distribution and Random draws from a lognormal
importantly, the bounded uniform distribution (which by distribution with mean = 1. (Slow
construction with finite scale for all q cannot be pre-wild randomness with finite and localized
randomness.) moments)
5. Pre-wild randomness: scale factor becomes infinite for
q > 2, e.g. the Pareto distribution with α = 2.5
6. Wild randomness: infinite second moment, but finite
moment of some positive order, e.g. the Pareto
distribution with
7. Extreme randomness: all moments are infinite, e.g. the
log-Cauchy distribution

Wild randomness has applications outside financial markets, e.g. it

has been used in the analysis of turbulent situations such as wild
forest fires.[7]
Random draws from a Pareto
Using elements of this distinction, in March 2006, a year before the distribution with mean = 1 and
Financial crisis of 2007–2010, and four years before the Flash crash α = 1.5 (Wild randomness)
of May 2010, during which the Dow Jones Industrial Average had
a 1,000 point intraday swing within minutes,[8] Mandelbrot and
Nassim Taleb published an article in the Financial Times arguing that the traditional "bell curves" that have
been in use for over a century are inadequate for measuring risk in financial markets, given that such curves
disregard the possibility of sharp jumps or discontinuities. Contrasting this approach with the traditional
approaches based on random walks, they stated:[9]

We live in a world primarily driven by random jumps, and tools designed for random walks
address the wrong problem.
Mandelbrot and Taleb pointed out that although one can assume that the odds of finding a person who is
several miles tall are extremely low, similar excessive observations can not be excluded in other areas of
application. They argued that while traditional bell curves may provide a satisfactory representation of
height and weight in the population, they do not provide a suitable modeling mechanism for market risks or
returns, where just ten trading days represent 63 per cent of the returns between 1956 and 2006.

Definitions

Doubling convolution

If the probability density of is denoted , then it can be obtained by the double

convolution .

Short run portioning ratio

When u is known, the conditional probability density of u′ is given by the portioning ratio:

Concentration in mode

In many important cases, the maximum of occurs near , or near and

. Take the logarithm of and write:

If is cap-convex, the portioning ratio is maximal for

If is straight, the portioning ratio is constant
If is cup-convex, the portioning ratio is minimal for

Concentration in probability

Splitting the doubling convolution into three parts gives:

p(u) is short-run concentrated in probability if it is possible to select so that the middle interval of (
) has the following two properties as u→∞:

I0/p2(u) → 0
 does not → 0

Localized and delocalized moments

Consider the formula , if p(u) is the scaling distribution the integrand is

maximum at 0 and ∞, on other cases the integrand may have a sharp global maximum for some value
defined by the following equation:

One must also know in the neighborhood of . The function often admits a "Gaussian"
approximation given by:

When is well-approximated by a Gaussian density, the bulk of originates in the "q-interval"

defined as . The Gaussian q-intervals greatly overlap for all values of . The Gaussian
moments are called delocalized. The lognormal's q-intervals are uniformly spaced and their width is
independent of q; therefore if the log-normal is sufficiently skew, the q-interval and (q + 1)-interval do not
overlap. The lognormal moments are called uniformly localized. In other cases, neighboring q-intervals
cease to overlap for sufficiently high q, such moments are called asymptotically localized.

See also
History of randomness
Random sequence
Fat-tailed distribution
Heavy-tailed distribution
Daubechies wavelet for a system based on infinite moments (chaotic waves)

References
1. Benoît Mandelbrot (1997) Fractals and scaling in finance ISBN 0-387-98363-5 pages 136–
142 https://books.google.com/books/about/Fractals_and_Scaling_in_Finance.html?
id=6KGSYANlwHAC&redir_esc=y
2. B. Mandelbrot, The variation of certain Speculative Prices, The Journal of Business 1963 [1]
(http://web.williams.edu/Mathematics/sjmiller/public_html/341Fa09/econ/Mandelbroit_Variati
onCertainSpeculativePrices.pdf)
3. B. Mandelbrot, New methods in statistical economics, The Journal of Political Economy
1963 https://www.jstor.org/stable/1829014
4. Benoit Mandelbrot, F.J. Damerau, M. Frame, and K. McCamy (2001) Gaussian Self-Affinity
and Fractals ISBN 0-387-98993-5 page 20
5. Philip Mirowski (2004) The effortless economy of science? ISBN 0-8223-3322-8 page 255
6. B. Mandelbrot, Toward a second stage of indeterminism in Science, Interdisciplinary
Science Reviews 1987 [2] (http://users.math.yale.edu/mandelbrot/web_pdfs/indeterminismIn
 Science.pdf)
7. The Economics of Forest Disturbances: Wildfires, Storms and Invasive Species by Thomas
P. Holmes, Jeffrey P. Prestemon, and Karen L. Abt. 2008. Springer: Dordrecht, The
Netherlands. 422 p. ISBN 978-1-4020-4369-7
8. Wall Street Journal May 11, 2010 (https://www.wsj.com/articles/SB10001424052748704370
704575227754131412596?mod=rss_com_mostcommentart)
9. Benoît Mandelbrot and Nassim Taleb (23 March 2006), "A focus on the exceptions that prove
the rule (https://fooledbyrandomness.com/FT-MandelbrotTaleb.pdf)", Financial Times.

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