How reserves, slack and simple rules of thumb help us deal with radical uncertainty. Why the next financial crisis is unlikely to be like the last one.
In this episode you’ll learn:
- Why the world can’t be solved but has to be lived.
- How slack and following rules of thumb can help us deal with radical uncertainty
- What are water rights.
- What is an emergent phenomena.
- How to invest like a cockroach.
How To Navigate Radical Uncertainty
Like many of you, I took a high school physics class that included an exercise in plotting the course of the earth around the sun using Kepler’s laws of planetary motion. It was one of the few instances I recall using math in high school to solve something useful.
What my physics teacher neglected to mention was that while a student can plot the course of one planet around the sun and determine where it is at any point in time, once two or more planets are added, even the greatest scientists in history, such as Isaac Newton, were unable to determine where three planets would be in the future based on their current position and velocity.
The Three Body Problem
It turns out this three-body problem cannot be solved using standard mathematics.
In his book, “The End of Theory: Financial Crisis, the Failure of Economics and the Sweep of Human Interaction,” Richard Bookstaber writes, “The three-body problem illustrates how easy it is to run into computational irreducibility…It seems it cannot be solved analytically. There is no apparent shortcut, no mathematical equation that can tell you the trajectory. In general, if you want to know where the planets will end up down the road, you have to ride along with them as they trace their paths, either in practice or simulation.”
What is amazing about that is there isn’t any randomness when it comes to planetary motion. The relevant variables are the planets’ masses, the distance between them and their velocity.
Yet, scientists have only discovered sixteen special cases, most of them using supercomputers, where the planets’ motion fits a pattern that allows for their future positioning to be accurately predicted.
Most of the time as Bookstaber points outs, “If you start the three planets on a course, they will follow complex and apparently random trajectories that finally end with one of the planets escaping the gravitational pull of the others.”
William Stanley Jevons, an English economist and logician, was one of the first academics in the mid nineteenth century to apply mathematical shortcuts to understand the economy.
Despite his efforts, he also recognized there was a problem in using math when it came to the human interactions that drive the economy.
He wrote, “If we are to apply scientific method to morals, we must have a calculus of moral effects, a kind of physical astronomy investigating mutual perturbations of individuals. But as astronomers have not fully solved the problem of three gravitating bodies, where shall we have a solution of the problem of three moral bodies?”
Life Has To Be Lived
Humans are changeable. They learn, grow and make decisions based on emotion and context—how they feel given what is going on in their lives at any given moment.
Economic models are based on logic and require humans to act in consistent ways from one person to the next and from one time period to the next because that is what is required for the mathematics to work.
Bookstaber writes, “It is a deeply held conviction within economics that our world can be reduced to models that are founded on the solid ground of axioms, plumbed by deductive logic into rigorous, universal mathematical structures.”
“Economists think they have things figured out, but our economic behavior is so complex, our interactions are so profound that there is no mathematical shortcut for determining how they will evolve.”
“The only way to know what the results of these interactions will be is to trace out the path over time: we essentially must live out our lives to see where they will go. There is no formula that allows us to fast-forward to find out what the result will be. The world cannot be solved; it has to be lived.”
When it comes to the economy, financial markets and our own lives, there is no way to know or accurately predict what is going to happen one, three or five years from now.
Bookstaber writes, “Fundamentally, we don’t know where we are going, and we don’t know who we will be when we get there…If we change with our experiences, and if we cannot anticipate those experiences or how they will change us, if we must live out life in order to know it, then a central underpinning of economics is ripped away.”
Bookstaber describes this unknowing as radical uncertainty. The world is full of surprises; outcomes and events that we didn’t anticipate.
Holding Reserves and Building Slack
In our financial lives, we can navigate radical uncertainty by holding reserves and building slack.
That means having some emergency savings and cash. It means not becoming too illiquid or overly aggressive in our investing.
Bookstaber writes, “During a crisis what matters is not relative value, the subtleties of relative expected earnings or constrictions in the supply chain. What matters is liquidity and risk. People dump risky and illiquid assets, and there is a flight to quality (toward assets that are liquid and less risky).”
Holding cash and perhaps even some long-term bonds provides a margin of safety to both protect against crisis and to be in the position to take advantage of opportunities that arise.