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Wednesday, 1 June 2011

Deep Time and the Fallacy of Frequency

Ice Age 6?

There was a time when geologists reckoned that we’d never see another Ice Age. This was when our understanding stretched back only as far as the last one. Then they discovered that there’d been not one Ice Age, but five, stretching away back into countless hundreds of millions of years.

One-off events, even ones as apocalyptic as the general freezing of the world, tend to be ignored: but repetitive ones are viewed very differently. Things that have happened multiple times before may happen again: frequency changes perspectives. Unfortunately the geological view of Deep Time isn’t shared by investors, whose event horizons rarely reach beyond the next quarter.

Usshering in a New Era

For a while humanity’s best guess at the age of the Earth relied on the calculations of Bishop Ussher, whose analysis of the ages of various Old Testament prophets, and much other scholarship, allowed him to confidently assess the beginning of time at 4004 BC. On October 23rd. At midday.

Of course, in geological terms this turned out not so much be wrong as to be a rounding error. However, judging the Bishop on the basis of our knowledge rather than his is simply inappropriate – Stephan Jay Gould mounted a defence of the primate in Fall of the House of Ussher : he was wrong, but he wasn’t stupid.

In fact the evidence that the age of the planet was much, much older than this mounted only slowly. It’s now impossible to put ourselves in the shoes of the men who figured this out, but the dawning realisation that the planet – and therefore the universe – was not thousands but billions of years old must have been a culture shock of the deepest kind.

Hutton's Geology

The man that originally wrought this transformation isn’t one of the great scientists we’re taught about, but a Scottish farmer and geologist by the name of James Hutton. Hutton’s eighteenth century investigations of Scottish geological formations led him to the belief that the Earth was subject to a long, slow and constantly repeating cycle: the idea of Uniformitarianism, that the geological forces that have formed the Earth are cyclical, unbelievably long and are still moulding it slowly and imperceptibly today. In fact this concept, Deep Time, was only confirmed by carbon dating technology in the second half of the twentieth century.

Hutton’s idea influenced Charles Darwin: the original conception of natural selection is based around the ideas of Deep Time and incremental change over its vast length. However, we now know that while uniformitarianism is correct in one sense in another it’s quite wrong: the world is shaped not only by constant processes but also by violent upheaval.

Glacial Progress

The geologist Louis Agassiz is probably the most well known of the men who made the break with uniformitarianism, drawing on the evidence of the erratic distribution of alpine rocks in his native Switzerland to propose a theory in which a great Ice Age pushed glaciers down and across Europe. Thus, rather than geology being shaped by gradual change it was sculpted by massive, one off events: catastrophism.

The debate between uniformitarians and catastrophists had – and still has – many dimensions. Agassiz never accepted the ideas of Darwin and the parallel between the end of the Ice Age and the biblical flood is too obvious to need further description. Although if you need some then there are hundreds of websites that’ll help you out. In time, however, a more nuanced picture has evolved.

Our planet is subject to continual, cyclical change as new material is forced up out of the planet’s core whilst the forces of nature ensure erosion and deposition. Yet we’re also subject to catastrophic events that have massive consequences for life. Even so, the fundamental of Deep Time remains true: our planet is over 4 billion years old.

Illusory Patterns in the Past

However, Agassiz was wrong in another way, as well. Our planet hasn’t been subject to one great Ice Age. It’s undergone at least five, and much of our expectation about the future is based on this understanding. Once scientists at the end of the eighteenth century realised that they were dealing with multiple Ice Ages it became inevitable that people would start worrying about future ones: in fact we can date our fixation with climate change from this period.

And this is a fundamental part of human psychology. We are inveterate pattern seekers and we project patterns we discern in the past and the present into the future. That some of these patterns are illusory and that the predictions are hopelessly ineffective dissuades us not one jot.

Our unfortunate knack of illusory pattern recognition doesn’t seem to be entirely random, either. As Whitson and Galinsky show there appears to be a link between a lack of self-control and a tendency to impute patterns where none exist. They speculate that:
“Lacking control will lead to illusory pattern recognition, which we define as the identification of a coherent and meaningful interrelationship among a set of random or unrelated stimuli (such as the tendency to perceive false correlations, see imaginary figures, form superstition rituals, and embrace conspiracy theories).”
Volatility Begets Lack of Control

Their experiment looked at a stock market scenario where participants were given information about two companies, some bad and some good. In both cases the ratio of good to bad information was 2:1 but there were double the number of statements about one company than the other: so company A had 16 positive and 8 negative statements while company B had 8 positive and 4 negative. Participants were also told whether market conditions were volatile or not and were then asked to report how many negative statements there were on each company.

Typically people will form illusory correlations around less frequent information – so the more limited the data, the more likely an illusory correlation is to form. In this case the experimenters predicted that occurances of the least frequent information – the bad information about the less reported company – would be overestimated and would lead to this company being traded less in more volatile conditions: because participants would unconsciously link exaggerated estimates of negative information to the more infrequently reported group. Which is, in fact, what happened.

Illusory Business Cycles

Now, of course, if these illusory pattern seeking behaviours are linked to a loss of control then unstable market conditions will likely trigger them. As the researchers state:
“The need to be and feel in control is so strong that individuals will produce a pattern from noise to return the world to a predictable state”.
Of course we’ll do this most frequently in the most volatile conditions and these will often be associated with catastrophes that we least expect. The odd thing is that the market speak is full of discussions about cycles – business cycles, Kondratiev cycles, Kuznets cycles and so on – as though the market is some kind of uniformitarian structure like the Earth. Yet when disasters strike – as they inevitably do given the unstable nature of our planet – the Japanese tsunami being simply the latest example of its type – we run about like headless chickens imposing illusory patterns on everything we see in an attempt to retain some fictitious semblance of control.

No Vestige of Control

The Earth, and markets, are governed both by the cyclical forces of uniformitarianism and the unspeakable crises of catastrophism. The patterns we seek in the natural cycles of Deep Time in the markets will eventually win, but in the short term investors can be subject to events that are simply out of their control. No amount of wishful thinking is going to change that and adopting investing principles that accept the inevitable and occasional loss of control is the best practice for those of us who seek a quiet life. Think deep value or income focussed investing.

Oddly enough James Hutton was a poor communicator, one reason why his incredibly important discoveries long failed to receive their just due. But there’s one phrase of his that echoes through your head long after you finish reading it. Of the Earth he wrote:
“The result, therefore, of this physical inquiry is, that we find no vestige of a beginning, no prospect of an end”.
Perhaps investors should apply the same reasoning to markets, when they’re in the depths of their latest catastrophe. Eventually geological normality will reassert itself; just make sure you have the money to wait that long.

Related articles: Cyclical Growth, Form and Fibonacci, The Lottery of Stockpicking, Your Financial Horoscope

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