Most people in finance operate under a giant self-deception: they think future economic trends are much more knowable than they actually are.
The economy is like a complex ecosystem. You cannot alter one piece of it without causing effects elsewhere in the system. Investors who understand this reality can also understand (and avoid) the hazards of over-confident investing.
Our discussion begins in Yellowstone National Park. In the late 1800s, Yellowstone's game population - its elk, bison, antelope and deer - began to disappear. So in 1886, the US Cavalry took over management of the park. And its first order of business was to help bring back the game population.
After a few years of protection and special feeding, the game population started to come back strong. But what the government didn't understand was that it was dealing with a complex ecosystem. You can't just change one thing and think that it won't also lead to cascading changes elsewhere.
The surging elk and deer populations ate a lot more. This caused the plant life to diminish. Aspen trees, for instance, started to disappear, eaten by the numerous elks. This hurt the beaver population, which depended on the aspen tree. The beavers built fewer dams. The beaver dams were important in helping prevent soil erosion by slowing the flow of water from the spring melt. Now the trout population took a hit, because it didn't spawn in the increasingly silted water. And so on and so on...
The entire ecosystem started to break down because of man's desire to boost the elk population. It got worse. In the winter of 1919-1920, more than half of the elk population died - with most of them starving to death. But the National Park Service chalked it up to predators. So it began killing wolves, mountain lions and coyotes - all of which only made the problems worse.
This anecdote from Yellowstone's past comes from Michael Mauboussin's book, Think Twice. He writes: "The population of the game animals began to experience erratic booms and busts. This only encouraged the managers to redouble their efforts, triggering morbid feedback loops."
By the mid-1900s, the Park Service managed to kill off nearly all of the predators. In 1926, it shot the last wolf.
This experience in Yellowstone sounds a lot like what's happening in our economy today. Congress and the Federal Reserve are so busy "rescuing" specific pieces of the economy that they fail to realize how these efforts are threatening other pieces of the economy.
Our government has propped up the auto manufacturers. It's propped up numerous banks, mortgage lenders and the world's biggest insurer, AIG. But the rest of the economy is still swooning.
In fact, portions of the government's rescue efforts are contributing to the economy's difficulties. Because the Fed is supplying so much credit at such low rates of interest to the big finance companies, these finance companies can make a lot of money by simply buying Treasuries, rather then lending to businesses. The result is that most small and mid-sized companies cannot get loans. If the Fed's did not supply credit so inexpensively, the banks would be forced to loan to businesses.
Unintended effects like this one produce unintended effects elsewhere, and before you know it, cause and effect are hard to discern...or to explain accurately. "Yet our minds are not beyond making up a cause to relieve the itch of an unexplained effect," Mauboussin writes. "When a mind seeking links between cause and effect meets a system that conceals them, accidents will happen."
That's why so many so-called experts are so often dead wrong. They think that know what's causing what. But they don't.
For instance, there is no shortage of financial experts who will tell their clients to put 15% of their portfolio here and 10% there or whatever. And these experts will have definite opinions on each of their recommended mutual funds. This one is better than that one. They'll give numbers. It will seem very concrete and real and "expert."
But guess what? Almost all the experts produced an identical 35% loss for their clients in 2008.
If an investor hopes to minimize or avoid losses of this magnitude, they must understand that economies are complex adaptive systems - replete with feedback loops and black swans and power laws. Investors must approach the future with humility. And that means fearing risk more than craving reward. A humble investor will also insist on a margin of safety in each investment.
I don't write about this philosophy very much, because it is kind of wonky. But these ideas inform how I look at markets, and are one reason why I try to stay rooted in boots-on-the-ground-type thinking and present-day facts.
I've been influenced by a number of thinkers about the unpredictability of economies and markets. A couple of my favorites would be Nassim Taleb, author of Fooled by Randomness, and Benoit Mandelbrot, author of The (Mis)behavior of Markets. Another useful book on these ideas is Mauboussin's More Than You Know. Mandelbrot writes a lot of highbrow stuff, but in this book he teamed up with Richard Hudson, a former Wall Street Journal editor, to reach a broader audience. Mandelbrot is a critically important thinker in finance. But he is not revered by academics.
As Paul Cootner, an MIT economist, put it: "If [Mandelbrot] is right, almost all of our statistical tools are obsolete. Almost without exception, past econometric work is meaningless." So there you go. Academics ignore him because if he's right, academia is pretty much a farce. Academics won't embrace Mandelbrot's ideas because their salaries depend on them not embracing those ideas.
So if you think that academia might be promoting a farce - for the first time ever, of course - you might want to examine Mandelbrot's ideas in more detail.
Regards,
Chris Mayer
for The Daily Reckoning Australia
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About the Author
Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer's essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning. He is the editor of Mayer's Special Situations and Capital and Crisis - formerly the Fleet Street Letter.
Comment by Nick Kemp on 15 December 2009:
I would back Mandelbrot against academia any day. In fact, as a trader searching for the fat right tail, I do it with my own money all the time.
History is littered with people who are rejected by the mainstream only to be proven right. Early astronomers were happily punished for having the temerity of thinking that the earth may be going around the sun. Fluid dynamics on submarines uses work on Chaos theory that once had its proponents banned and funding cut from universities that hired them. Mandelbrot's earlier work was rejected but is now happily taken as correct.
The people rejecting Mandelbrot's work ignore the 'abnormal' number of high volatility market events because they don't fit under the standard bell curve. Try explaining your bad losses away to your significant other using that one!
The 'other' scary modern version of this is the way climate change sceptics find it hard to get published in science journals