Wednesday, April 18, 2018 / Perth Australia / By Niekie Jooste
In this edition of "The WelderDestiny Compass":
What the wise do in the beginning, fools do in the end. - Warren Buffett
The quote by Warren Buffett given above sounds rather odd. Surely if wise people have figured out a good way to do something, then it should be advantageous for everyone to follow their example. Well, in many instances that would in fact be totally correct. It is what technical fields such as engineering is built upon.
To understand where Warren Buffett is coming from, we need to keep in mind that he is an investor. His field of study and action is within the realm of economics. An economy is an example of a complex system, and complex systems behave totally differently than the systems us engineering types normally study.
Today we will take a brief look at what a complex system is, and why it tends to behave in rather non-intuitive manner. Once we understand the concept of how complex systems work, we will be better equipped to wield our predictive powers with care. We will also be able to apply some critical thinking to claims by people that want us to believe that they can predict and control the outcomes in complex systems.
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Now let's get stuck into this week’s topics...
So, here is a definition of a complex system that was found on a university website:
A complex system is any system featuring a large number of interacting components (agents, processes, etc.) whose aggregate activity is nonlinear (not derivable from the summations of the activity of individual components) and typically exhibits hierarchical self-organization under selective pressures.
That is a mouthful, so I will try to explain it in a simpler way.
When we technical people think of a complex system, we think of an intricate machine that has many moving parts. Let's say something like a jet aircraft. A jet aircraft is however not a complex system. It is a complicated system, but complicated is not the same as what we are talking about, because if we know what we are doing, we can still plot out how every part of the aircraft interacts with every other part in a predictable manner. If that was not the case, perfectly fine aircraft would behave in totally unpredictable ways, which we know does not happen.
On the other hand, a complex system has components that "self organize", based on "rules". Unfortunately the rules are not fixed. If we "fiddle" with the system, then the rules change without us having any say about it, and often in unpredictable ways. The best we can do is to try and figure out what the rules are under different circumstances, and see if that gives us useful information.
Typically complex systems are comprised of groupings of independently "thinking" and acting components, that are trying to maximize their own "benefit" within whatever situation they find themselves in.
Examples of complex systems are: economies, corporations and human bodies. Well, all animal bodies really.
So here is where Warren Buffett's quote comes in. In an economy, once somebody figures out how to "get an edge", and that knowledge becomes widespread enough, then many of the participants within that economy start to change their behaviours based on that knowledge. Once that happens to a large enough extent, the rules that gave rise to the "knowledge" changes.
In other words, economic models are of limited use if they are going to be used to actually "fiddle" with the system, because then the rules change. In fact, the more you fiddle, the more unstable and less predictable the system becomes.
It is this dynamic that leads to market bubbles and economic crashes and crises.
There are millions of economists in the world. Thousands with PHD's working for reserve banks and governments. Many of which have received Nobel prizes for the economic models that they have developed. Unfortunately, despite all these models, we still have economic bubbles, crashes and crises.
Despite their best efforts, these economists are unable to "engineer" inflation when they want it, or prevent hyper inflation when they don't want it, or ensure that everyone in an economy has a job and a comfortable living.
We can get another example from Warren Buffett himself. He made a fortune using a value investing approach to buy the right companies. He was so successful, that his method became one of "the best" ways to invest. The problem is that if a big part of the market is looking for undervalued companies, then eventually there will be very few undervalued companies left to invest in. This is a problem that Warren Buffett is facing right now. He has billions of dollars to invest, but he can't find the undervalued companies to invest in.
The other "big thing" in investing is computer algorithmic trading. It looks great, because one can design an algorithm that predicts which stocks are going up or down, and trade accordingly on an almost instantaneous basis.
The problem is that it won't be long before there are other computers that use similar algorithms. Once that happens, the system becomes unstable, and we start to see the "flash crashes" where markets lose big amounts within minutes, and then suddenly correct again.
Another obvious example of how fiddling with complex systems leads to the rules changing, is in medicine. Medicines are developed, but most of them lead to unintended side effects. Side effects that, over time, can result in bigger problems than the conditions that they were designed to treat.
One pill results in a side effect, so you need to take another pill for the side effect. The second pill has its own side effects, so you need a third pill to deal with those etc. In short, modern medicine is great for acute medical problems, but as a general rule, chronic conditions just do not respond well.
So, are we doomed? Is it impossible to work with complex systems to result in some beneficial outcome? No, it is possible, as long as the models we develop do not result in changes of the rules. This means in effect that any fiddling that we perform in the system should be to stabilise the rules that would give the best outcome "on balance".
Basically it means that we should not try to manipulate the system so that it favours a particular group within the system, but we should try to establish the outcome that provides the best outcome for all "on balance". Normally this means that the intervention should be as little as possible. In fact, the "intervention" should be designed to result in balance.
On an economic note, we could make sure that economies are as free as possible, rather than manipulate interest rates. Pushing down short term interest rates to artificially low levels would stimulate people to take on more debt than is good for the economy, while punishing savers.
In the case of chronic disease, rather try to treat the person with diet and lifestyle, than medicine. It takes longer to try and figure out what the problem is, so that the right lifestyle choices can be found, but once the factor is established that can balance the system again, the disease should theoretically disappear. This process is much more time consuming and cumbersome than popping pills, but should give better outcomes in the long run.
In short, when working with complex systems, we should understand our limited ability to engineer the outcomes we want. Especially when those outcomes are aimed at giving us an edge over other participants in the system. While such actions are possible, they can only ever be successful for a limited time until the instability caused in the system naturally "corrects". This normally results in some kind of pain for the system.
Politicians are obviously the most keen on manipulating such economic and societal complex systems. In this light, let me end on a quote from Ronal Reagan:
"The most terrifying words in the English language are: I'm from the government and I'm here to help."
Yours in welding
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