Significance of Butterfly effect on Financial World

The butterfly effect is an anecdote about a butterfly flapping its wings in a part of the globe, which leads to a hurricane in another part. How does this happen?

Explained The Butterfly effect

Professor Edward Lorenz invented the butterfly effect, also known as the "ripple effect", in 1961. Lorenz believed that even the smallest changes in one environment could have profound ripple effects in the future. Lorenz studied the impact of entering 0.506127 into a weather forecasting model, and how it produced wildly different predictions. He found that the butterfly effect can be easily applied to economic conditions as well as natural disasters.

The Butterfly Effect in Finance

A small gesture of friendship from one country to another can have a significant impact on the stock exchange in that country. It's not surprising that financial experts believe that the butterfly effect can be used as a predictor of the behavior and performance of financial markets. Globalization has had dramatic effects on the world over the past 30 years. Even a slight bump in a country's stock market could have devastating consequences for another.

Let's take, for instance, the collapse of Lehman Brothers in the United States back in 2007-2008. The fall of Lehman Brothers in the United States has been widely attributed as the "butterfly" that caused the global economic collapse. It was the cause of one of the worst recessions ever recorded. Another example of a catalyst is the widespread spread of COVID-19 on the Wuhan market, which has caused a global pandemic that has sunk the global economy, trade and businesses.

Significance in Finance of the Butterfly Effect in Finance

The ripple effect is a key factor in the financial industry, as shown by the examples above. These are just a few of the ways that finance uses knowledge about the butterfly impact.

1. Diversification Principle

It is possible to lose capital on investments at any time. This is why it is important to be prepared. Diversification is a way to mitigate the potential damage from random variables that could impact the quality of your investments. Diversifying your portfolio will help you to protect yourself from the dangers of putting all your eggs into one basket. A single small action can lead to a stock market crash. Therefore, diversifying your portfolio is an excellent way to ensure steady income.

2. Compounding Principle

The ripple effect is responsible for the compounding effect that comes with increasing wealth. Anyone can start their financial journey by setting aside income and investing it in a financial instrument that earns interest. The reason is that the longer you keep your money invested, the greater the potential for exponential growth in your savings. Let's say you begin saving Rs5000 per month and put it in a high-interest savings account with a nominal interest of 9%. Your savings will reach Rs3.7 lakhs after 5 years. Your savings will increase exponentially to Rs9.7 Lakhs after 10 years.

3. Eco Investing

The third important point the butterfly effect holds in the financial world's financial landscape is the importance of aligning personal values and investments. The millennial generation seems to be more inclined to invest in social causes, also known as eco-investing. This is in contrast to the generations before them. Eco investing is based on the idea that every rupee can have a ripple impact. Investors who are dedicated to a particular cause -- animal welfare or female education, city development, access to healthcare for poorer countries, and so on -- will put their money into these causes.

Conclusion

Although the butterfly effect is widely used in finance, it's important not to use it in every case. There is no way to prove that two seemingly unrelated events are related using the butterfly effect. The second problem is that the phenomenon is susceptible to the biases of hindsight, where one can only be certain that one event caused another. When they look back,