Via: compoundingmyinterests.com Michael Mauboussin of Credit Suisse Group AG (NYSE:CS) is one of the best strategists on Wall Street and a thought leader who consistently introduces some of the most compelling topics to the financial community. It is therefore no surprise Mauboussin is now Chairman of the Board of Trustees at the Santa Fe Institute, an organization which specializes in the multidisciplinary study of complex adaptive systems. I recently had the privilege of interviewing Mauboussin about his involvement with the Santa Fe Institute and his thoughts on complexity. Enjoy (and be sure to follow the links to some fascinating further readings):
Elliot: Now that you’re Chairman of the Board of Trustees at the Santa Fe Institute, what are your goals and visions for how to more broadly inject SFI’s lessons on complexity into the financial community’s understanding of markets?
Michael: In my role at SFI, the primary goal is to make sure that the Institute does, and can, do great science. The unifying theme is the study of complex adaptive systems. But the goal is to have a place where there’s support for important, transdisciplinary research.
That said, I would love to continue to see this type of thinking work its way into our understanding of financial markets. That is happening to some degree. One example is Andrew Lo’s work on the Adaptive Market Hypothesis. Another example is Blake LeBaron’s work on markets using agent-based models. I think it’s a more complete way of viewing markets than a standard rational agent model or the assumption of the absence of arbitrage. The problem is that modeling complex adaptive systems is a lot messier than those other approaches.
Elliot: When we last met at an event introducing The Success Equation to SFI members in New York, I asked you what the right “success equation” is for a young investor. Your response was to “keep coming to these events.” How did you first learn about the Santa Fe Institute? And how did you come to embrace the SFI?
Michael: I first learned about SFI in 1995 at a Baltimore Orioles baseball game, where Bill Miller was my host and the proselytizer. He explained how this new research group dedicated to the study of complex systems was coming up with cool and useful insights about business and markets. Specifically, he was taken with Brian Arthur’s work on “increasing returns.” This work showed that under some conditions returns actually move sharply away from the mean. This is counter to classic microeconomic thinking that assumes returns are mean-reverting.
In many ways I was primed for the message. I had been doing a lot of reading, especially in the area of science, and so this way of thinking made sense to me from the beginning.
Elliot: Did you have a bias towards one market philosophy before you adopted the complex adaptive system mental model?
Michael: Although I had a solid liberal arts background before starting on Wall Street, I had very little background in business or finance. As a result, I had few preconceived notions of how things worked. It’s a challenge to come up with clear conclusions based on an observation of what happens in markets. On the one hand, you see clear evidence that some people do better than the indexes and that there are patterns of booms and crashes over the centuries. These suggest that markets are inefficient. On the other hand, there’s also clear evidence that it’s really hard to beat the market over time, and that the market is more prescient than the average investor. So for me, at least, there was an intellectual tug of war going on in my head.
I have to admit to being struck by the beauty of the efficient markets hypothesis as described by the economists at the University of Chicago. At the forefront of this, of course, was Eugene Fama, who recently won the Nobel Prize in part for his work in this area. What’s alluring about this approach is that it comes with a lot of mental models. You can equate risk with volatility. You can build portfolios that are optimal relative to your preference for risk. And so forth. Because you can assume that prices are an unbiased estimate of value, you can do a lot with it. The market’s amazing ability to impound information into prices impresses me to this day.
So it was with this mental tug of war as a backdrop that I learned about the idea of complex adaptive systems. Suddenly, it all clicked into place. A simple description of a complex adaptive system has three parts. First, there are heterogeneous agents. These can be ants in an ant colony, neurons in your brain, or investors in a market. Second, these agents interact leading to a process called “emergence.” The product of emergence is a global system that has properties and characteristics that can’t be divined solely by looking at the underlying agents. Reductionism doesn’t work.
What instantly drew me to this way of thinking is that it describes markets very well and it is very common in nature. The central beauty of this approach is that it provides some sense of when markets are likely to be efficient—in the classic sense—and when inefficiencies will creep in. Specifically, markets tend to be efficient when the agents operate in a truly heterogeneous fashion and the aggregation mechanism is working smoothly. Diversity is essential, both in nature and in markets, and the system has to be able to take advantage of that diversity. There are some neat examples in experimental economics to show how this works. It’s really wondrous.
On the flip side, when you lose diversity the system can become very inefficient. And that’s also what we see in markets—diversity loss leads to booms and crashes. Now the loss in diversity can be sociological, in which we all start to believe the same thing, or it can be technical, such as the winding up or winding down of a leverage cycle. But here we have a framework that accommodates the fact that markets are pretty darned good with the fact that they periodically go haywire. And SFI was at the center of this kind of thinking.
Elliot: It’s interesting that your answer on what theory of markets you subscribe to is not in the “black or white” vein whereby one must be in one camp and one camp only. It seems like much of the divisiveness in today’s discourse (in many arenas) stems from people’s unwillingness to see these kinds of shades of grey, though as you suggest, that mentality is not for everyone. Do you meet resistance from people when explaining your stance? Is there a way to get others to embrace “complexity” when people have an innate desire for linear, orderly explanations that are essentially either/or answers?
Michael: Most of us are uncomfortable with ambiguity—we’d rather just have a point of view and stick to it. But in markets, the real answer clearly lies between the folks who believe that markets are perfectly efficient and those who believe it’s largely inefficient. By the way, if you think the market is mostly inefficient there is no reason to participate because even if you have a sense that you are buying a dollar at a discount there is no assurance that the market will ever recognize that value. So some degree of market efficiency is essential even for those who believe that markets have inefficiencies.
My goal is less to get people to change their view and more to establish a better understanding of how things work. Once you learn about markets as a complex adaptive system and appreciate its implications, I find it difficult to go back to a more traditional point of view.
Elliot: In More Than You Know, you said, “The best way to describe how I feel following a SFI symposium is intellectually intoxicated.” Are there steps you take following these events to transform the ideas you’ve learned and the relationships you’ve built into expanding the scope of your own knowledgebase? And how are you able to harness this intoxication into productive output?
Michael: I wish I could be more systematic in this regard, but I think it’s fair to say that the ideas from SFI have permeated every aspect of my work. Perhaps a couple of examples will help make the point.
I’ve already mentioned conceptualizing markets as a complex adaptive system. This alone is a large step, because rather than simply moaning about the limitations of standard finance theory, you have a framework for thinking about what’s going on.
I’ve also already mentioned Brian Arthur’s work on increasing returns. Many businesses are being defined less by their specific market segment and