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Chaos Theory and Investing

I’m no mathematician or physicist, but I’ve always found the concept of chaos theory to be fascinating. The main idea of chaos theory (as I understand it anyway) is that:

  • Every event is the result of literally thousands of different variables interacting, and
  • Changing just one of those variables (even a seemingly insignificant one) can cause events to unfold in an entirely different way.

Real life example

For me, the idea hits home in that I can trace several major aspects of my life (including the city I live in and the woman I’m married to) directly back to a birthday present my best friend received more than a decade ago.

It sounds crazy to say, but if my friend Matt’s aunt (whose name I don’t know and whom I’ve never met) had given him a different gift for his twelfth birthday, my life would look completely different than it does today.*

I suspect that if you take a few moments to think about it, you’ll find that your life probably has at least one similar event–something seemingly small/insignificant that turned out to have astonishingly far-reaching consequences.

So what does this have to do with investing?

Chaos theory and picking stocks

The same small-events-with-unpredictably-large-consequences phenomenon that occurs in the lives of people occurs in the lives of businesses as well. The success or failure of a business can hinge entirely upon who the salespeople and executives of the business happen to know (or meet). As silly as it might sound, a business’s fate can be wildly influenced by a seemingly random conversation between two parents at a grade-school softball game.

The takeaway is that–if we’re to believe the ideas behind chaos theory–then there’s no sense in trying to pick stocks, as it would be literally impossible to account for the multitude of things that could determine a business’s success or failure.

Chaos theory and timing the market

Of course, if the number of factors that go into choosing one individual stock are too numerous to keep track of, keeping track of the factors affecting the stock market would be even more impossible. End result: Don’t even think about trying to time the market.

What do you think?

What are your thoughts on all this? Does this chaos theory idea–to which I’m sure I haven’t done justice–make sense? Or do you think it’s hogwash? Is it reasonable to believe that an investor can successfully predict the fate of a given company?

*For anybody who’s curious: The gift was a deck of Magic: The Gathering cards. Matt and I ended up getting really into the game, and from ages 14-17 we traveled across the country to play in tournaments. On one trip to Chicago, I fell in love with the city. I ended up attending Loyola University Chicago, where I met my wife.

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  1. Ah, chaos theory 🙂 It is amazing how these tiny things can affect our lives. And when you are picking stocks, you are more likely to be more vulnerable to the vagaries of these small changes in direction.

  2. Well, you seem to be a smart guy, but you may have missed something. All the butterflies in the world flapping their wings about are highly unlikely to cause any hurricanes that wouldn’t have formed anyway. Similarly, the majority of minuscule events do not decide the fate of a business. Certainly you could trace a major event in any company’s history to a chaotic event, such as a coin flip or a conversation at a softball game, but this will not mean that you can now make great picks by spying on soccer moms. On the other hand, high quarterly or annual growth is highly probable to correlate with a price increase, regardless of anybody’s aunt. As an investor your challenge is to use the best prediction machine on this planet: the human brain, to predict which of an innumerable possible investments are safe enough for your comfort level, and which of those will yield the highest return. Do meteorologists say “there are too many birds behaving chaotically, we cannot predict where this hurricane will go,” ? No, they make a prediction as accurate as they can with the tools and knowledge they have, and they make two more predictions, where in one an unusual percentage of chaotic events align to push a hurricane in one direction, and an opposite prediction. What they are left with is a probable hurricane path, which will most likely not be followed, but is a good general expectation, and a range of all possible paths within a certain probability, usually over 95%.

  3. Hi “anon.”

    First, let me be clear that I place chaos theory more in the “fascinating and worth discussing/thinking about” category rather than the “absolutely, unquestionably true” category.

    You said “Similarly, the majority of minuscule events do not decide the fate of a business.” I’d agree with that completely. Clearly, most small events have very few significant consequences. All I’d argue is that some small events will have surprisingly large consequences.

    But clearly trying to determine which of those events will have out-sized consequences is completely pointless. Or, as you put it “this will not mean that you can now make great picks by spying on soccer moms.”

    One quick note: If you chose to be anonymous simply to protect your privacy, that’s fine, and I can completely appreciate that. I just hope that you don’t feel like you need to withhold your name simply because you’re disagreeing with an article I wrote. I rather welcome disagreement, as it often makes for far more interesting conversation.

  4. Miguel Gomez says

    Completely agree with you! The market is completely random and unpredictable (e.g. a company gives better than expected returns and the stock plummets?) and just trying to beat it most investors end up making less than the market when the market moves up and losing more when it moves down.
    Costs are a huge factor, as you have mentioned in previous posts and as I have noted it in my website, but also the extreme greed/fear that drives investors to buy/sell in the wrong time. The worst part is that all happens with the approval of unethical financial “advisors” that take the commission with every investor mood swing.

    Keep up with the great posts!

  5. Ohhh man Magic?! Daaaaang…. that is kind of funny =)

    Reminds me of the beginning of this webcomic!

    The general idea is similar to black swans no? Unpredictable events that have huge consequences… (or choose your own adventures…) I admit it’s still just on my to-read list =/

  6. @Miguel: Thanks for stopping by to comment.

    @SJ: Why’d I have a feeling you were going to make a comment about the gaming? 🙂

    Yes, Taleb’s ideas seem (to me, anyway) to be very in line with chaos theory. Personally, I enjoyed Fooled by Randomness (which I just read, probably having a great deal to do with me writing this post) more than Black Swan, but they’re both quite entertaining/intriguing IMO.

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