Robustness

If our normal statistical tools can’t describe the type of uncertainty experienced in financial markets, how can we compensate, or at least manage our exposure? Hints can be found in nature. Our financial systems have much in common with systems found in nature. Markets are not emotionless interactions of data, but rather they are the meeting place of action driven by human emotion. The interactions of investors is similar to the interactions of living things in other natural systems.

One example is an ecosystem. It includes resources such as water and food. It includes various types of animals, predators and prey. It includes the external elements such as weather. All of these things combine into a system that finds a point of equilibrium. This stability is, however, in a state of constant flux,including both cycles and directional change.

The human brain is ill-equipped to cope with this type of system. Our brain searches for patterns, and prefers order. We try to simplify and optimise. However, this type of thinking isn’t well-suited to natural systems. Trying to order nature has led to crises relating to biodiversity. Steps taken to optimise a system have led to its failure.

If ordinary human thinking cannot adequately manage natural systems, including financial systems, what principles can we adopt from natural systems that we could apply to our thinking about investment markets? The main purpose of a natural system is survival. Growth is not necessarily a goal. This may also be true in financial systems. Small companies (that don’t fail) tend to grow, but large companies reach a certain point where they can no longer expand profitably and they tend to decline. This “business lifecycle” is not unlike the lifecycle of a living organism. Within a group of living things, various organisms will achieve various degrees of dominance, but none will remain forever. Despite this, the species can continue independent of each individual.

Continuing with that analogy, no one organism is so large that it can individually affect the entire species. The largest land animal is the elephant. The loss of a single elephant doesn’t impact the future of the species or the balance of the ecosystem. Another example is mosquitoes. On a summer day, I may kill a dozen. Even spraying pesticide in breeding ponds by the city doesn’t seem to have much effect on next year’s population of mosquitoes.

An ecological system is not optimised. There are not “just enough” elephants and “just enough” mosquitoes. A robust system contains duplication and redundancy. Take, for example, the human body. I have two ears, two two eyes, two arms, two legs. If I lose the use of a single limb, the other can compensate. Ideally, a single organism will have multiple purposes. You know those birds that live near the hippopotamus? They eat bugs, they produce eggs, they keep the hippos clean and I bet they even have a pleasing song.

These same ideas apply to finance. The system should not be optimised. It should, instead, contain duplication and redundancies. No single element should grow out of proportion. Experience should be prized over models. In this way, instead of fruitlessly trying to reduce volatility, we can be prepared for real risk and survive to invest another day.

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