Edgar E. Peters, Patterns in the Dark: Understanding Risk and Financial Crisis with Complexity Theory, John Wiley & Sons, 1999, 222 pages, $39.95

Is it any wonder why smart traders love volatility, while amateurs shun it? It's because smart traders understand complexity theory. And with the help of this book, you may too.

One of the nifty things about complexity theory is that it isn't very complex at all. If you depend on markets -- and who among us doesn't? -- complexity theory is all you need to stop worrying about why seemingly random events appear to have a pattern.

You could hardly ask for a better mentor to this seemingly arcane but important subject than Edgar Peters. Peters is the chief investment strategist for the multibillion-dollar

PanAgora Asset Management

in Boston, which uses quantitative systems to trade stock, bond and currency futures. A former student of

Harry Markowitz

, he is also the author of

Fractal Market Analysis

(1994) and

Chaos and Order in the Capital Markets

(1996).

Patterns in the Dark

has two main theses: Uncertainty and risk are not the same thing, and uncertainty is a necessary condition if capital markets are to prosper, evolve and grow.

Many people believe that risk and uncertainty amount to the same thing. They don't. Risk is the possibility of loss or injury. Uncertainty is the condition that describes doubt or ignorance. But, "the definition of uncertainty says nothing about the chance of loss," writes Peters.

Though simple, complexity theory does require some leaps of faith, such as the fact that in complex, adaptive systems like the markets (or weather), uncertainty actually increases trading opportunities.

Why? If everybody knew where the price of

Microsoft

(MSFT) - Get Report

stock would be a month from now, how could a trader make money? In fact, it is the uncertainty of where it will be in a month that gives traders an opportunity to profit. If you didn't have uncertainty, markets wouldn't work.

But uncertainty does not mean utter chaos. There is a difference between complex and random systems, and the difference lies in the impact of relationships. In a random system like rolling dice, each roll is isolated, and there is no relationship between one roll and the next.

But complex systems are always evolving in time. What happens today can influence tomorrow's action. Although more difficult to predict, complex systems like markets depend on the past to anticipate the present and the future. In short, the market is no random walk: It is influenced by events from the past.

Peters also stresses the importance of market structure and why it determines whether a market is resistant to unexpected shocks. Healthy complex systems, like healthy markets, keep working even if one piece breaks down. They are decentralized, and they adapt to competing changes in the environment. But while there is no centralized big picture, participants have a good, but not perfect knowledge of how they work.

Peters uses the Internet as an example of a complex adaptive system that, like any good market, has five general characteristics:

    A unifying purpose A decentralized, loosely connected structure Feedback in which the elements of the system influence each other, which in turn creates An ability for adaptation, and Chance, which in financial markets is sometimes called surprise.

Taken pragmatically, all this explains why an unruly market such as the U.S. stock market remains vibrant and healthy, while controlled markets -- some of the emerging stock markets, for example -- offer fewer opportunities.

Put together, we get a complex, adaptive system that responds to its environment by continually reinventing its structure to be a near-optimal, but never perfect system. Its inherent uncertainty provides continual opportunities for those who learn to deal with uncertainty.

Reading this book will tell you a lot more than just how successful markets work. By accepting uncertainty's critical role in a healthy market, you will re-examine your approach to both trading opportunities and risk management of those opportunities. It's more complex, but remember, complexity is your friend.

Desmond MacRae is a New York-based freelance journalist specializing in banking, finance and investments. He is a regular contributor to Managed Account Reports, Global Investment and Plan Sponsor, and can be reached at

desmondmacrae@worldnet.att.net.

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