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Monday 13 July 2009

Investing In The Rear View Mirror

Time’s Arrow

If we were granted the ability to reverse time’s arrow in order to replay history it’s highly unlikely that the world as we know it would recreate itself. The chances of humanity being here at all are so remote as to be infinitesimal. Our survival is a miracle, the chances of it happening again remote.

Basically, if we were to rewind and replay the video tape of history almost any prediction we might make would almost certainly not come true. And this process continues today – the world is too complex, too contingent, too damned unpredictable to allow for any trustworthy view of the future. Which is why people who think they can predict the course of macroeconomics are wishful thinkers, not serious investors.

Human History

It may seem that humans are the invincible and inevitable conquerors of all we survey but our DNA tells a very different story. Our species successfully escaped the trap of sub-Saharan Africa only once. Only about 150 people bridged the gap to Asia Minor to populate the rest of the planet.

Indeed our genes tell us that homo sapiens has been to the edge of utter extinction, its numbers reduced to levels so small as to make the survival of the species a matter of sheer luck. At times a single volcanic eruption or a bad case of mammoth-roast food poisoning might have wiped us out. Puzzled sentient cockroaches would still be arguing over how evolution could have allowed a creature so weak to exist at all.

As individuals our own individual existences are a probability so low as to not be worth computing – hundreds of generations of crash meetings of gametes and random mutation combining to create the words in front of you. A strange kind of pinnacle, that.

Predestination or Parallel Worlds?

To argue that the world as we find it today was inevitable is to argue for predestination – that everything that is, was always destined to be and that everything to come is already pre-ordained. As a philosophy of life that’s a dire prospect. Yet if we believe that we have some control over the events that shape the world we must also accept that life is contingent on those events, random happenings that could have been otherwise leading to outcomes that could have been different.

There are strong philosophical arguments based around the sheer improbability of the universe being created exactly right for supporting life. On one hand some people argue that this is evidence for God’s hand in creation, a new kind of Creationism. Others think that this world is simply one of an infinite number of possibilities and our existence is due to us happening to occupy the right one. Some of us think philosophers should get a useful job, flipping burgers or chasing hubcaps.

Unknown Future, Unusable Past

The point of this diversion is to argue two things. Firstly that the future is as unknowable as the past and making claims about it in any general sense is about as sensible as sacrificing goats or reading tealeaves. Although in the latter case at least you can get a tasty stew and a refreshing cuppa at the end of it.

Secondly the past is no basis for making generalisations about the future. Most people relying on history to predict what’s yet to come assume that it consists of a series of data points and the key thing is to pick the right one. So we need to figure out whether we’re partying like 1929 or 1931 or 1970 or whatever and then draw the appropriate conclusions. Only this is wrong, wrong, wrong – the past is not a series of discrete data points that we can draw on to generate predictions but a single continuous data set.

In fact, to get enough data to model the future we need to inspect the market events of all of the parallel universes where different conditions apply. So far we don’t know how to do that, although we’re trying to tunnel through by creating a Black Hole under Switzerland which we’ll start just as soon as we figure out where the contractors put the fuse box.

The Nearest Run Thing

Applying this model of random events to the world of business leads to a whole bunch of conclusions about how much or how little we can possibly know about the companies we invest in and the likely trajectory of their futures. Leslie Hannah looked at the survivorship rate of the world's largest 100 industrial corporations between 1912 and 1995: only 20 companies are on both lists. These are the largest companies; as Hannah says of smaller corporations their "...probability of survival over the century approximates to zero". So much for long-term buy and hold.

Rewind the tape to 1912 and you'd find that the main emerging markets were South Africa, Mexico and Russia. You'd not have found Japan on anyone's list, less still South Korea which didn't even exist as an independent country. Stuff happens, all the time, most of it unpredictable.

The idea that the structure and apparent order of the world around us is an illusion is quite frightening, yet contra-factual studies of history seem to show exactly this. It would have taken very little to have triggered nuclear war in the 1980's or 1960's, sheer luck sent the Japanese carrier fleet to the bottom at Midway, Hitler would have overwhelmed Britain in 1940 had he chosen to invade, the Confederacy would probably have raised enough cotton money to win the Civil War had they been able to hold New Orleans for a few more months and Napoleon would have won Waterloo had he thrown the Imperial Guard into the battle before Blucher’s Prussians arrived. As Wellington said – “it was the nearest run thing you ever saw in your life”.

And it always is.

Financial Crises

Barro and Ursua in Macroeconomic Crises since 1870 show that there has been about one financial crisis per year, somewhere in the world, in the last 150 years, with an accompanying stockmarket decline of around 30% - giving the rather depressing probability of one occurring to each of us every 20 or so years. Despite the vast array of computing power, the starry line ups of economic geniuses and the cleverness of the mathematical models being brought to the party this number isn’t improving. In fact, if anything, the false security being generated by models that appear to show the extinction of risk is increasing the problem. Before LTCM collapsed in 1998 its Nobel Prize winning management was worried that they weren’t taking on enough risk to generate the returns they wanted.

There’s a certain smug satisfaction in knowing that the billions of dollars that the financial industry pours into ever cleverer and more opaque methods for managing risk is ultimately pointless. It’s not that the world is more complex than we know, it’s that it’s more complex than can ever know. This satisfaction is, however, somewhat dissipated by the knowledge that it’s our money they’re wasting on this fatuous pursuit of El Dorado or, as they like to call it, “bonuses”.

Life Is For Living, Not Fortune-Telling

Spending our time trying to second-guess the macroeconomic future is a hopeless task. The next crisis won’t look like the last, we won’t see it coming. We can’t even know when the current one started until the dust settles: we can have no idea what next week, next month or next year will bring.

The best we can do is to operate on the basis that everything will, more or less, be alright. Spending our lives examining economic data and news stories like an amateur fortune-teller is a waste of valuable living time. We can’t reverse history so let’s make the best of the limited time that we’re each granted and leave the job of Gypsy Rose Lee to the economists who, at least, are paid to get things wrong.

The Goldilocks Enigma: Why Is the Universe Just Right for Life?This Time Is Different: Eight Centuries of Financial FollyWhen Genius Failed: The Rise and Fall of Long-Term Capital Management

Related Articles: Hindsight Bias, Contrarianism, Regression to the Mean: Of Nazis and Investment Analysts


  1. I think that great philosopher Donald Rumsfeld explained it best when he referred to the problem of not knowing what we don't know.
    Dealing with the lack of knowledge is the hardest part of creating an investment process, or making any plans at all.
    Trying to seek information that you can never get is, as you say, futile. But, hey, what would Wall St or The City do if they all thought that?

  2. "Puzzled sentient cockroaches would still be arguing over how evolution could have allowed a creature so weak to exist at all."
    This reminds me that I miss Gary Larson and The Far Side. :)