It is said that less experienced and sophisticated investors should avoid trading complex products. But what does it mean when one says that a given product is complex? There are two ways to see this. The conventional way may be quite misleading. It is in fact suggested that a financial product is highly complex when it is ‘difficult’ to architect or when it requires involved mathematics, such as stochastic calculus, which is beyond the reach of most people. Products such as options, futures, CDOs or CDSs, not to mention exotic derivatives, are said to be highly complex. Products composed of multiple tranches are also said to be complex.
However, the difficulty in conceiving and actually putting together such products is only one side of the story. Consider a watch movement. Most people who wear a wristwatch have no clue as to how it is built or how it functions. Some watch movements are deliberately made to be complicated. However, when it comes to using a watch and to controlling its functioning things are very easy. It usually comes down to one or more crowns which are used to set the time or to wind the mechanism. The functioning of a running watch is simple and easy to understand. Basically, the system is highly complicated on the inside, while on the outside even a child can fathom its simple dynamics. Clearly, a similar logic may be applied to financial products.
Evidently, things can also evolve the other way around: a product may be single to conceive and yet exhibit intricate dynamics. So, what ultimately counts, is not the effort behind making a product but rather the way it behaves once it has been launched on the market. But there is more. The degree of complexity of financial products is not a static property. It changes along with the markets, sometimes matching their speed, or even anticipating them. Because of this non-stationary property of complexity, one should also indicate the corresponding spanned period of time. In effect, over a short-term a product may behave as highly complex only to appear as far simpler when considered over a longer period. The conclusion of all this? Given the variability of complexity, one should check every time that one wishes to focus on a determined product. As they say, the only constant is change.
Highly complex financial products are characterized by convoluted dynamics and are generally more volatile and less predictable in terms of performance.
When applied to stocks or other financial products such as ETFs, futures or bonds, complexity takes into account the following characteristics of the dynamics of the corresponding price:
• Memory/correlation – how current price depends on past values
• Ruggedness – how rocky and uneven the evolution of the price is
• Variability – the degree of instability, jitter, volatility
• Discontinuities and non-linearity
The above attributes affect negatively our ability to understand the dynamics of stock prices and therefore impact the capability to make robust estimates of their future values. As a general rule, less experienced investors should avoid financial products which exhibit complex dynamics as they may generate surprising behaviour.
The distribution of complexity of over 5000 financial products is illustrated below. It is far from normal.
Examples of complexity levels of various financial products are illustrated below.
NB. The complexity measures/levels indicated in the tables below are not static properties. Due to market turbulence they change in a dynamic fashion.
The complexity of stock dynamics can range from very low to very high.
Treasury bonds generally exhibit dynamics that is generally less complex.
The complexity of ETF dynamics can range from very low to very high.
Like in the case of ETFs or stocks, the dynamics of funds may be characterised by high complexity.
The complexity of futures may range from low to high.
VIX-based products are generally characterised by complex dynamics.