The butterfly effect refers to the anecdote of a butterfly flapping its wings in one part of the world, leading to a hurricane occurring in a separate part of the world. But how does this occur?
The Butterfly Effect Explained
The butterfly effect, otherwise called the ‘ripple effect’ is a phenomenon coined by Professor Edward Lorenz in 1961. Lorenz theorized that the smallest of changes in one surrounding could leave drastic ripple effects at some point in the future. He studied how entering 0.506 into a weather model instead of entering 0.506127 led to incredibly different results in what weather the model predicted. His studies suggest that the butterfly effect is applicable not just to weather conditions and natural disasters but can easily be applied to economic conditions and financial markets.
Butterfly Effect in Finance
Even a small political gesture by one country towards another can affect the stock market of the latter nation. So it’s no surprise that many financial experts have theorized that the butterfly effect can be used to predict the behavior of financial markets. With globalization taking hold of the world in the past 30 years, even a small bump in the stock market of one country could create drastic consequences in another part of the world.
Take, for example, the fall of the United States’ Lehman Brothers back in 2007–2008. This fall has been widely theorized as the catalyst (butterfly) for the collapse of global economies worldwide, causing one of the biggest recessions the global economy has seen. Another way of seeing a catalyst in action is the spread of COVID-19 in the Wuhan market which has now led to a widespread pandemic across 2020 causing the global economy, trade, and businesses to plummet.
Significance of the Butterfly Effect in Finance
Based on the aforementioned examples, it’s clear that the ripple effect holds a lot of significance in the financial world. Here are a few ways in which the world of finance makes use of knowledge about the butterfly effect.
1. Diversification Principle
Capital loss on one’s investments can occur randomly, as it often does, and being prepared for that is essential. The principle of diversification works to counteract the damage associated with random variables impacting the quality of your investments. By diversifying your portfolio, you are fortifying yourself by not putting all your eggs in a single basket. The smallest of actions today can cause an entire stock market to crash, hence, keeping a basket of investments in a variety of asset classes and financial instruments, is a very good way to maintain a steady flow of income earned.
2. Compounding Principle
Even the compounding effect associated with growing wealth appears to have its roots in the ripple effect. The simple act of setting aside income in a financial instrument that gives you interest is recommended to anyone at any point in their financial journey. This is because the longer you remain invested, the more exponential growth you can see in your savings. Let’s assume you start saving ₹5000 monthly and putting it into a high-interest savings account where your nominal interest is 9%. After 5years your savings will amass to ₹3.7 lakhs. After 10 years, however, your savings will grow exponentially to ₹9.7 lakhs.
3. Eco Investing
The third point of significance the butterfly effect has in the financial world is that of carefully aligning your personal values with your investments. Millennials seem to be adopting the approach of investing in social causes — otherwise known as eco investing — more in comparison to the generation above them. Eco investing rests on the principle that every rupee put out into the world can have a ripple effect. Investors who are committed to particular causes — animal welfare, female education, city development, accessibility of healthcare to poorer nations, and the like — are putting their money into these causes.
Although we observe the vast application of the butterfly effect in finance, it’s wise to not be liberal in using it to explain every situation. The main criticism of the butterfly effect is that there is no way to prove causation between two seemingly random events being related. Secondly, the phenomenon is always prone to the bias of hindsight wherein one is only sure that one event may have caused another “in hindsight” i.e. when they look back at it.