- What is often lacking is his third principle: the "habits of mind" that seek to link together different bodies of knowledge.
- Cultivating Franklin's 'habits of mind' is the key to achieving Charlie Munger's 'worldly wisdom'. The key is finding the linkages that connect one idea to another. Fortunately, the human mind already works this way.
- The originality of Darwin’s theory lay in the idea that the struggle for survival was occurring not only between species but between individuals within the same species. If having a longer beak, for example, increased a bird’s chances of survival, then more birds with long beaks would be more likely to pass this advantage on. Eventually, the longer beak would become dominant within the species.
- By this process of natural selection, Darwin theorised, favourable variations are preserved and transmitted to succeeding generations. After several generations, small gradual changes in the species begin to add up to larger changes—thus, evolution occurs.
- “The central point of his whole life work is that capitalism can only be understood as an evolutionary process of continuous innovation and creative destruction.”
- In a word, evolution took place in the stock market via economic selection. How does economic selection occur? Remember that in Farmer’s analogy, a biological population is capital and natural selection occurs by capital allocation. This means capital varies in relation to the popularity of the strategy. If a strategy is successful, it attracts more capital and becomes the dominant strategy. When a new strategy that works is discovered, capital is reallocated—or, in biological terms, there is a change in population. As Farmer notes, “The long-term evolution of the market can be studied in terms of flows of money. Financial evolution is influenced by money in much the same way that biological evolution is influenced by food.”
- Why are financial strategies so diverse? The answer, Farmer believes, starts with the idea that basic strategies induce patterns of behavior. Agents rush in to exploit these obvious patterns, causing an ultimate side effect. As more agents begin using the same strategy, its profitability drops. The inefficiency becomes apparent, and the original strategy is washed out. But then new agents enter the picture with new ideas. They form new strategies of which any number may become profitable. Capital shifts and the new strategy explodes, which starts the evolutionary process again. It is the classic El Farol Problem described by Brian Arthur.
- Will the market ever become efficient? If you accept the idea that evolution plays a role in financial markets the answer would have to be no. Each strategy that eliminates an inefficiency will soon be replaced in turn by a new strategy. The market will always maintain some level of diversity, and this we know is a principal cause of evolution.
- To illustrate the phenomenon of emergence, let’s look in on a familiar social system: an ant colony. Because ants are social insects (they live in colonies, and their behavior is directed to the survival of the colony rather than the survival of any one individual ant), social scientists have long been fascinated by their decision-making process.
- One of the ant’s most interesting behaviours is the process of foraging for food and then determining the shortest path between the food source and the nest.3 While walking between the two, ants lay down a pheromone trail that allows them to trace the path and also show other ants the location of the new food source.
+ At the beginning, the search for food is a random process, with ants starting out in many different directions. Once they locate food, they return to the nest, laying down the pheromone trail as they go. But now comes the very sophisticated aspect to collective problem solving: the colony, acting as a whole, is able to select the shortest path. If one ant randomly finds a shorter path between the food source and the nest, its quicker return to the nest intensifies the concentration of pheromone along the path. Other ants tend to choose the path with the strongest concentration of pheromone and hence set off on this newly discovered short path. This increased number of ants along the trail deposits even more pheromone, which further attracts more ants until this path becomes the preferred line. Scientists have been able to demonstrate experimentally that the pheromone-trail behavior of the ant colony solves for the shortest path. In other words, this optimal solution is an emergent property of the collective behavior of the ant colony. - By definition any complex adaptive system can never be ‘efficient’ or ‘stable’ because it is inherently a ‘self regulated system’ and it's keeps adapting over time in an evolutionary fashion or one may call it a ‘self organising system’. Hence the title of the book, ‘Every time I find the meaning of life, they change it’ is very, very apt indeed. At some point these ‘self-organising systems’ reach ‘self-organised criticality’
- Although Johnson's maze is a simple problem-solving computer simulation, it does demonstrate emergent behavior. It also leads us to better understand the essential characteristic a self-organising system must contain in order to produce emergent behavior. That characteristic is diversity. The collective solution, Johnson explains, is robust if the individual contributions to the solution represent a broad diversity of experience in the problem at hand. Interestingly, Johnson discovered that the collective solution is actually degraded if the system is limited to only high-performing people. It appears that the diverse collective is better at adapting to unexpected changes in the structure.4 To put this in perspective, Johnson's research suggests that the stock market, theoretically, is more robust when it is composed of a diverse group of agents--some of average intelligence, some of below-average intelligence, and some very smart--than a market singularly composed of smart agents. At first, this discovery appears counterintuitive. Today, we are quick to blame the amateur behavior of uninformed individual investors and day traders for the volatile nature of the market. But if Johnson is correct, the diverse participation of all investors, traders and speculators--smart and dumb alike--should make the markets stronger, not weaker. Another important insight from Norman Johnson was his discovery that the system, as long as it is adequately diverse, is relatively insensitive to moderate amounts of noise (by which he means any sort of discordant, disruptive activity). To prove the point, Johnson intentionally degraded an individual contribution; he learned his action had no effect on participants' finding the shortest path out of the maze. Even at the highest levels of disruption, the collective behavior, after a brief postponement, was able to discover the minimal path. Not until the system reached its highest noise level did the collective decision-making process break down.
- Diana Richards, a political scientist, is investigating what causes a complex system of interacting agents to become unstable. Or, in Per Bak's terms, she is trying to determine how a complex system of individuals reaches self-organised criticality.
- According to Richards, a complex system necessarily involves aggregation of a wide number of choices made by the individuals in the system. She calls this "collective choice." Of course, combining all the individuals' choices does not always result in a straightforward collective choice; nor should we assume the aggregate choice, which is the sum of individual choices, always leads to stable outcomes. Collective choice, says Richards, occurs when all the agents in the system aggregate information in a way that allows the system to reach a single collective decision. To reach this collective decision, it is not necessary that all the agents hold identical information but that they share a common interpretation of the different choices. Richards believes that this common interpretation, which she calls mutual knowledge, plays a critical role in the stability of all complex systems. The lower the level of this mutual knowledge, the greater the likelihood of instability.
- An obvious question at this point is how people select from a collection of choices. According to Richards, if there is no clear favorite, the tendency of the system is to continually cycle over the possibilities. You might think this cyclical outcome would lead to instability, but according to Richards, it need not if the agents share similar mental concepts (that is, mutual knowledge) about the various choices. It is when the agents in the system do not have similar concepts about the possible choices that the system is in danger of becoming unstable. And that is clearly the case in the stock market.
- If we step back and think about the market, we can readily identify a number of groups that exhibit different meta-models. We already know that fundamentalists and trend followers possess different meta-models. What about macro-traders who are not interested in individual companies but are interested only in directional changes in the overall market? What about long-short hedge funds? What about statistical arbitrageurs versus entrepreneurs? What about quantitatively driven strategists that seek low volatility-absolute return strategies? Each of these groups works from a different reality, a different sense of how the market operates and how they should operate within it. In reality, there are many different meta-models at work in the stock market, and if Richards's theory is correct, this all but guarantees periodic instability. (Hence, individual stocks behave very differently as compared to the overall behaviour of the stock market).
- An individual who has given this subject a great deal of thought is John Allen Paulos, professor of mathematics at Temple University. Paulos is a best-selling author, best known for Innumeracy (1988) and A Mathematician Reads the Newspaper (1995). Both books are enjoyable reads, but it was his 1998 book, Once Upon a Number: The Hidden Mathematical Logic of Stories, that is best connected to our philosophy chapter.
- The idea that people with high IQs could be so bad at decision making at first seems counterintuitive. We assume that anyone with high intelligence will also act rationally. But Stanovich sees it differently. In his book, What Intelligence Tests Miss: The Psychology of Rational Thought, he coined the term "dysrationalia"--the inability to think and behave rationally despite having high intelligence.
- Research in cognitive psychology suggests there are two principal causes of dysrationalia. The first is a processing problem. The second is a content problem.
- Stanovich believes we process poorly. When solving a problem, he says, people have several different cognitive mechanisms to choose from. At one end of the spectrum are mechanisms with great computational power, but they are slow and require a great deal of concentration. At the opposite end of the spectrum are mechanisms that have low computational power, require very little concentration, and make quick action possible. "Humans are cognitive misers," Stanovich writes, "because our basic tendency is to default to the processing mechanisms that require less computational effort, even if they are less accurate." In a word, humans are lazy thinkers. They take the easy way out when solving problems and as a result, their solutions are often illogical.
- The second cause of dysrationalia is the lack of adequate content. Psychologists who study decision making refer to content deficiency as a "mindware gap." First articulated by David Perkins, a Harvard cognitive scientist, mindware refers to the rules, strategies, procedures, and knowledge people have at their mental disposal to help solve a problem. "Just as kitchenware consists in tools for working in the kitchen, and software consists in tools for working with your computer, mindware consists in the tools for the mind," explains Perkins. "A piece of mindware is anything a person can learn that extends the person's general powers to think critically and creatively."
- Mindware gaps, he believes, are generally caused by the lack of a broad education. In Perkins's view, schools do a good job of teaching the facts of each discipline but a poor job of connecting the facts of each discipline together in such a way to improve our overall understanding of the world. "What is missing," he says, "is the meta-curriculum--the 'higher order' curriculum that deals with good patterns of thinking in general and across subject matters."
Extracted From: Cliff Notes of the book: ‘Investing: The Last Liberal Art’