02 Oct 2015 Hurricanes, Economies, Markets, and Butterflies
“And a butterfly can flutter its wings over a flower in China and cause a hurricane in the Caribbean.
I believe it. They can even calculate the odds.
It just isn’t likely and it takes…so long.”
Robert Redford as card shark Jack Weil in Havana
“In chaos theory, the butterfly effect is the sensitive dependence on initial conditions in which a small change in one state of a deterministic nonlinear system can result in large differences in a later state. The name of the effect, coined by Edward Lorenz, is derived from the metaphorical example of the details of a hurricane (exact time of formation, exact path taken) being influenced by minor perturbations such as the flapping of the wings of a distant butterfly several weeks earlier. Lorenz discovered the effect when he observed that runs of his weather model with initial condition data that was rounded in a seemingly inconsequential manner would fail to reproduce the results of runs with the unrounded initial condition data. A very small change in initial conditions had created a significantly different outcome.” The Butterfly Effect – Wikipedia
Whether the subject is hurricanes, economies, or markets, the immeasurable number of variables and the sensitive dependence on initial conditions make prediction of outcomes darned difficult if not impossible. Yet we continue to try.
Efforts to predict where hurricanes are headed doubtless increase awareness and save lives and property, regardless of their accuracy or inaccuracy. We hope they continue to improve their ability.
But markets and economies have so many more butterflies to contend with than weather systems – like human emotions and the reactions those emotions cause.
Hedge funds, referred to above, are partnerships organized to use high risk strategies to gain significantly larger returns than the markets themselves offer. In fact, any form or active management has a similar objective. Common to all efforts to outperform markets is that they are deterministic in their philosophy. Merriam Webster defines determinism as follows: “occurrences in nature, or social or psychological phenomena are causally determined by preceding events or natural laws.” By watching subtle shifts in market and economic trends, active managers believe they can find opportunities to profit before others do. The problem – there are just too many darned butterflies causing ‘minor perturbations’ to possibly understand what at any given time will result in ‘large differences in a later state.’
From a financial standpoint, a better strategy than trying to figure out where a powerful force is going to go is to efficiently harness its power to move yourself in the direction you want to go.