Summary –This essay tells the story of chaos theory and its importance in finding order where there was only chaos before—and then applies chaos theory to the practice of risk management—thereby turning uncertainty into
Quotation – Chaos theory is a branch of mathematics focused on the behavior of dynamic systems that are highly sensitive to inputs.
Wikipedia – A young professional having breakfast might decide to eat another piece of toast and risk missing the bus. She runs for the bus but, alas, just misses it. Then, as she waits for the next bus, an old friend comes along and offers her a ride. On the way to the office the friend tells her of a new movie production company he has formed and that he is looking for a partner. She has always wanted to make movies and so she accepts his offer of partnership on the spot.
Systems. The systems approach views the world as a complex organization of interconnected parts. The universe is a system. One scopes a system by defining its boundary and identifying which elements are inside the system
Chaos Theory. Research has shown that many simple nonlinear systems act chaotically and unpredictably. Chaos theory has broad implications for many disciplines. In risk management it suggests that rather than trying to
1) The Butterfly Effect; 2) Universality; 3) Inner Rhythms; and 4) Fractals.
1) The Butterfly Effect refers to the cause and effect relationship between seemingly small disturbances in air flow caused by the flapping of a butterfly’s wings which can ultimately cause severe changes in weather patterns thousands of miles away. The butterfly effect refers to systems that are highly sensitive to inputs. Small changes in one state of a deterministic nonlinear system may result in much large differences in the following states. It is impossible to foresee all of the twists-and-turns in life and in business. All that we can do is have a clear set of values and objectives, and then make the best of every situation. Risk management, like chaos theory as described by the butterfly effect, must concern itself with outcomes rather than with pathologies. For example, a risk manager is not so much interested as to whether an increase in revenue comes from an increase in price or a decrease in the foreign exchange rate, as she is in predicting revenue for the following year. Consider a system that has 1 as an input and 10 as an output. If the input is increased slightly to 1.01, the output might shoot up to 10,000. In this case, outputs are chaotic and highly sensitive to inputs—and thus embody the butterfly effect.
2)Universality in chaos theory argues that common ground exists between otherwise divergent phenomenon. With statistics, universality is the view that the properties of a large class of systems are independent of the contents of the system. Universality exists in chaos when a large number of moving parts come together. Traditional scientific theories stop at the edge of the forest, unable to penetrate the dense underbrush of apparent randomness. At a certain point the quantification of phenomena breaks down and further understanding can only take place by observing the emergence of patterns common to parallel systems. A physicist studying the movements of planets around the sun as a way of further understanding the movement of electrons around the nucleus of an atom is an example of using parallel systems to understand divergent phenomena. Chaos theory focuses on phenomena that are unpredictable, but yet have obscure connectedness to other seemingly unrelated phenomena. The edge that chaos theory holds over traditional science is that it does not focus on specific outcomes, but instead observes obscure subtle tendencies and patterns common to different systems that had previously gone unnoticed. As far as risk management is concerned, the key tenet of universality is that all risks share a good number of common traits. Consider that out-of-the-money put options function in exactly the same way as property insurance, with the deductible being the difference between the current price and the exercise price. Furthermore, because of their similarities, individual risk elements should be assessed in aggregate as a way of understanding how they interact with each other and how they impact the whole organization.
3)Inner Rhythms describe the workings of systems and how they tend to steady or unsteady states. Chaos theory addresses the conditions necessary for a system to reach and maintain a steady state. Inner rhythm is an exploration of the inner landscape. We can see inner rhythms in terms of biological systems. Equilibrium represents a state of total control, whereas a steady state is a balance between chaos theory and control. When a biological system reaches equilibrium, it is dead. A certain amount of chaos is healthy in a system. Inner rhythms are the practice of surrendering to the moment and to our body’s wisdom. It is an opportunity for allowing, feeling, and expressing all the emotional qualities and textures that make up the human experience. I dare ask the question of what it is like to welcome inner chaos? Also, what is it like to be firmly rooted in our own center, true to ourselves, while sharing space and interacting with others? And what unfolds when we carry this embodied truth
4) Fractals are natural phenomena exhibiting self-similar patterns at every scale. They stem from chaos theory and are fractions of dimensions that include everything from clouds to oil prices to galaxy clusters.
Conclusion. This essay tells the story of chaos theory and its importance in finding order where there was only chaos before in risk management and many other disciplines. Chaos theory teaches us to expect the unexpected. When one comes across a chaotic system, most people just give up. Instead, we can turn disorder into order by simply applying the extensive methods of chaos theory.