One of my favorite concepts when thinking about financial markets is complex adaptive systems, a concept that may sound overwhelming but is very easy to understand when thinking about piles of sand.
Listen now and learn:
- An easy way to understand complex adaptive systems
- The benefit to thinking of the stock market like a sandpile
- Implications for your investment strategy
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Show Notes
One of my favorite concepts when thinking about financial markets is complex adaptive systems.
The idea of complex adaptive systems might sound overwhelming, but an experiment conducted by physicist Per Bak makes the concept easier to understand.
If you drop one grain of sand at a time onto an empty table, a small, cone-shaped pile begins to form. As the pile grows, eventually a grain of sand will hit the pile and trigger an avalanche.
If you’ve ever watched sand run through an hourglass, you might have noticed this dynamic in action. As the sand pours through the top glass and the pile below grows, small avalanches of sand start cascading down the side of the cone-shaped pile.
The longer the pile avoids an avalanche, the bigger the eventual sand avalanche will be.
Bak’s experiment was designed to determine the exact conditions that would trigger that avalanche, but he found the sandpile to be completely unpredictable. Avalanches sometimes occurred after hundreds of grains were added. Sometimes they happened after thousands.
Bak came to realize the timing of an avalanche was not a function of the size of the pile or number of grains of sand, but instead was related to the interactions between those individual grains of sand.
The more grains of sand in the pile, the more interactions that occur between the individual grains and the more difficult it is to predict the next avalanche.
Eventually, the pile reaches a critical point (called self-organized criticality) in which the pile transforms into something more complex and gains properties that must be considered separately from the individual pieces.
In other words, you can’t study the individual grains of sand and understand the pile in its entirety.
Emergence in Financial Markets
Complex adaptive systems aren’t necessarily complicated. It’s the emergent behavior that arises from within these systems of individual agents that are more complex.
Consider a kaleidoscope in which the rules governing the function of the system are simple. However, small changes in the initial conditions of the system have significant effects that result in a rich variety of patterns. Even if you understand the rules governing the kaleidoscope, it is impossible to precisely anticipate how a small change will alter the patterns you see.
The same concept applies to the pile of sand. The rules governing the individual grains of sand are simple, but it’s difficult to predict when an avalanche will occur because of the way different grains of sand interact and adapt to each other.
Financial markets are another example, with millions of participants interacting with each other. Each participant brings diverse tastes and trading rules into the system. These rules adapt over time based on feedback, and what emerges from interactions of investors is what Adam Smith famously called the “invisible hand.”
Adam Smith’s invisible hand suggests that when people are allowed to trade freely, then self-interested traders in the market would compete with each other for profit opportunities, which in turn would drive supply and demand towards an equilibrium price.
In other words, the millions of market participants competing for profits lead to highly efficient markets in which current prices reflect all available information and any inefficiencies in market prices cannot be systematically exploited.
This is a big part of what makes forecasting financial markets so difficult.
People place too much importance on explaining individual pieces of the market and not enough on how people perceive those pieces will interact with each other.
Even if you are aware of this dynamic, very few people have the capability to master the ever-changing mix of calculus and psychology.
The Problem with Predictions in Nonlinear Systems
A nonlinear system is one that does not produce the same result every time even though the inputs and conditions are the same. With the sandpile, you never know which grain of sand is going to cause an avalanche or how big the eventual avalanche will be because (again) each grain of sand uniquely interacts with other grains to create a pile that is slightly different each time.
Like piles of sand, financial markets are also nonlinear systems. But they are far more complex. Sandpiles are simply made up of interacting grains of sand. Financial markets are comprised of millions of interconnected inputs that adapt and learn over time.
All too often investors say some form of the following:
“I’m worried about __________ and think the market is in trouble. I want to reduce my exposure to stocks or make portfolio changes to prepare.”
That blank space is always something different.
Politics, the dollar, national debt, monetary policy, entitlement system, war, valuations, market highs, interest rates, Eurozone, China, etc. Most people fill in the blank with something specific after reading popular print or internet publications, listening to “pundits,” or tuning in to social chatter.
Not only does this line of thinking entirely ignore the crowd’s perception, it oversimplifies the many variables that impact market movements.
The stock market is a complex adaptive system in which linear thinking – A causes B and B causes C – isn’t sufficient.
Most non-professional investors (along with many professionals) use this type of linear reasoning when thinking about the stock market because the human brain is obsessed with precisely linking cause and effect.
Understanding the Financial Markets as Complex Adaptive Systems
Our innate human tendency to seek clean-cut reasons behind everything around us makes us highly susceptible to linear thinking.
Exacerbating this is the fact that financial media presents its viewers with Wall Street “experts” that succinctly describe past events by explaining specific causes that led to specific market movements, all after the fact.
Deeper Reading: Why Expert Predictions Are Bullsh*t
The point isn’t that cause and effect don’t exist, but that they aren’t proportional. Large fluctuations are more the result of the interactions within the complex adaptive system and less attributable to external or environmental factors.
If we start thinking of financial markets more like piles of sand, then we can no longer assume that a given action or event will produce a given reaction.
What All This Means for You as an Investor
There are some basic takeaways we can draw from thinking of financial markets more like sandpiles:
Avalanches will eventually occur, so it is important you have a plan in place.
Rather than constantly worry about when or why the next avalanche is coming, you should plan on avalanches occurring with a similar frequency and magnitude as they have in the past.
Of course, we are in the midst of a downturn right now, so if you didn’t have a plan in place for it, now is actually a good time to work with someone to take advantage of the investment and planning opportunities that lower prices create. By carefully assessing your willingness and ability to risk, you can build a portfolio you can stick with through poor market conditions.
Cause and effect are not neatly linked.
People place way too much emphasis on a few specific data points that allow for a narrative that closely link cause and effect.
Complex adaptive systems take on additional characteristics that can’t be accounted for by simply weighing the individual parts. This is a big reason it’s impossible to make accurate predictions about the market.
Ignore predictions from Wall Street “experts.”
Good investing is boring, but the media creates a sense of urgency and encourages bold predictions as if they are the source of an informational edge. Nobody is going to get major media attention for saying, “there’s no way to know what markets will do next.”
Predicting a complex adaptive system is a futile exercise. That’s why understanding this concept and how it applies to investing is so important.
Thanks for listening, and until next time…to long-term investing!
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Long-term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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