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A few years ago I read about this term called “ergodicity” in a few places and found it to be quite a fascinating idea.Then, a while back, one of my mathematically oriented ex-
students (Punit Sanwalani) wrote to me about it and nudged me to teach this idea to his juniors at MDI. We exchanged material on the subject and I spent the last few months
working on this idea. Today, I will tell you about this idea of ergodicity and what it means for investors as well as business managers.
Ole Peters
https://twitter.com/ole_b_peters
https://ergodicityeconomics.com/author/olebpeters/
https://www.youtube.com/watch?v=LGqOH3sYmQA
https://www.youtube.com/watch?v=f1vXAHGIpfc
A big part of what I will tell you today is based on the excellent work of Ole Peters, who is a Fellow at the London Mathematical Laboratory. He is also a professor at Santa Fe Institute. Peters has done a
lot of work on ergodicity. He has a few wonderful talks on the subject on youtube which I highly recommend.
To understand ergodicity, let’s use an example from one of Ole Peters’ talks. The example is that of a favorable game…
Rules
1. You're given a USD 100 and you invest this money in this game
2. If the coin lands heads, you win 50% of your wager
3. If it lands tails, you will lose 40% of your wager
4. The game keeps repeating - you play continuously
So depending on how the coin lands on successive tosses, you will get these successive trajectories of wealth.
This is one trajectory over 5 tosses - T T H T H.
Remember, this is a good bet. And I want to know what happens if I keep playing.
So I play it for 60 minutes. I toss the coin once a minute, for 60 minutes. A total of 60 coin tosses. And I get this trajectory.
But this is the trajectory I got. It’s just one sequence. If someone else had played this same game, then depending on the randomness in the situation, he would have gotten a different trajectory right? In
fact, if 10 people play this game - that is if 10 people toss a coin once a minute for 60 minutes, each one of those 10 people will have his own trajectory.
Imagine 10 people do this for 60 minutes. And each one plays the game according to the rules for an hour and those trajectories are plotted on this chart. Some people will do very well because they got
a lot of heads in the beginning and not many tails later on. Some will do poorly if they got a lot of tails in the beginning and the money shrank by 40% on each landing of tails. Some people will go broke.
But it’s a good game, and 10 trajectories have a lot of noise. So what happens if 20 people play this game according to the rules for an hour?
HTTTHHHTTTHTTTHTTTTHHTTHT
THTHHTHTHHHHTHTTHHHTTTHT
HTTTTTTTTTHTTTHTHTTTTHTHHT
TTHHHTTTTTHHTTHHHTTHHHHH
TTHHTTTTTTHTTTTHHTTTTHHTTH
TTHHTTHTHTHHTTTHTTHTTTTHT
THTTTTTTTTTHTTTTTHHHHHTHH
TTTHHTTTTHHTHHTHTTTHTTTTH
This is a random sequence of 312 coin flips. Notice some streaks. This is very much part of randomness.
Peter Bets on Heads Paul Bets on Tails
Example from Innumeracy: Mathematical Illiteracy and its Consequences by John Paulos
Imagine two friends bet on a coin which is flipped a 1,000 times. Peter bets on heads. Paul bets on tails. Peter is ahead at any given time if there've been more heads up until then, while Paul is ahead if
there've been more tails. Peter and Paul are each equally likely to be ahead at any given time, but whoever is ahead will probably have been ahead almost the whole time. If there have been one
thousand coin flips, then if Peter is ahead at the end, the chances are considerably greater that he's been ahead more than 90 percent of the time, say, than that he's been ahead between 45 percent
and 55 percent of the time! Likewise, for Paul.
The reason this result is so counter-intuitive is that most people tend to think of deviations from the mean as being somehow bound by a rubber band: the greater the deviation, the greater the restoring
force toward the mean. The so-called gambler's fallacy is the mistaken belief that because a coin has come up tails several times in a row, it's likely to come up heads on the next few flips.
But the coin has no memory. It’s extremely improbable that a losing streak of 5 flips will be followed by a similar winning streak. But even if it happened, then in our original game where you went down
40% if you landed tails and went up 50% if you landed heads, then losing steak of 5 tails followed by a winning streak of 5 heads, will take you from 100 to 8 to 59. Still down 41%.
But it’s a good game with favorable odds, and those 10 trajectories have a lot of noise. And we want to reduce the noise. So what happens if 20 people play this game according to the rules for an hour?
This is what happens. We get 20 trajectories. Looks so cool. All those swings - ups and down.
But what’s happening on average? We can take those twenty trajectories and simply average them and plot them on a chart.
This is that chart. It shows what happens to the wealth of 20 people, on average, if each one of them plays the game by flipping a coin once a minute for an hour - a total of 60 flips. Now, you may think
that on average, the wealth should have gone up. But in this case, it hasn’t.We are not getting the results that we should be getting. We are not getting what our intuition tells us. Maybe there is still too
much randomness. So how do we reduce the randomness? We do this by making even more people play this game for an hour and then average their results and plot them on a chart.
So we make 1,000 people play this game according to the rules, and average their resulting wealth at each toss, for a total of 60 tosses for each player and plot this on a chart. This is what the chart
looks like. Now, this makes sense. It’s a good bet, so, ON AVERAGE, the wealth should increase. That’s what our intuition tells us, right? And this is exactly what’s happening.
But there is still noise. So let’s reduce it further by making a million people play this game for an hour.
Aha! Now the noise is gone. There is no uncertainty left anymore. And we virtually eliminated the noise it by making a million people play this game according to the rules. Each one tosses a coin once a
minute for 60 minutes. The average wealth rises very neatly, very nicely. Just as we would have expected. There was a 50/50 chance of either losing 40 percent or gaining 50 percent so, ON AVERAGE,
we should be gaining in this in this game and this is exactly what happens.
Average result of a million people each of whom played a favorable game for
an hour.
But what’s important for ME is not what happens, ON AVERAGE, to the wealth of one million people. What’s important to ME is what happens to ME! And MY RESULTS of this game will depend on the
trajectory I will end up on…
–Mark Buchanan
https://aeon.co/ideas/how-ergodicity-reimagines-economics-
for-the-benefit-of-us-all
There’s an important lesson there which is this: No matter how good the game, there is always a chance of encountering a long enough sequence of bad luck which will take me out of the game. And I
do not want that to happen. So I must do whatever I can to stay in the game…
I'm really interested in one trajectory so I want to see if I can get rid of the noise in this system in a different way. Until now, we got rid of the noise by getting more and more people to play the same
game for an hour and then averaging their results to arrive at the ensemble average/
The other way is to reduce noise through time and not through more people. So I play for this game for a long long time and see what happens to ME.
This is what happens when I play for an hour. This is the trajectory I got and these are the results.
This is what happens if I play this game once a minute for a whole day. That is 24 hours. The green portion is what happened when I played for an hour - in the previous slide.
This is what happens when I play for a week. The green portion depicts what happened in the previous slide, when I played for a day - that is 24 hours.
And this is what happens when I play this game once a minute for a year. The green portion in the chart depicts the previous slide - that is what happened when I played for a week.
The noise has completely disappeared so there's really no reason to believe that there's any uncertainty in this result but I'm losing.
So we get these two completely different perspectives, One is this ENSEMBLE perspective where averaged the results of one million people and the second is the TIME perspective where we just let
TIME take care of the fluctuations and get rid of the randomness so that we can make some sense of what's going on.
In the ensemble perspective, the average result is a gradual rise in wealth - but as I will show you, what is really happening is that there are a few outliers - lucky individuals who are pulling up the
average. But they have only played for an hour. But in the time perspective, over time - see the chart relating to the time perspective - everyone will lose.
In the time perspective, everyone will lose. Now, I didn’t pick a particularly unlucky fellow. If you play this game long enough - no matter how lucky you are in the beginning, you will lose. This is a not a
winning game. In the long run, it’s a losing game. For EVERYONE.
Now many of you would have figured out why this is happening. Why does everyone lost this game in the long run? And I will give you the answer to that puzzle in a couple of minutes.
But before I do that, I want to go back to the ensemble average and show that the average result - a gradual rise in wealth - is not representative of reality. So let’s go back to the ensemble average.
This is the ensemble average. The average result of one million people playing this game for an hour. All charts, including this one are log scale. So notice at the end of one hour, the average wealth is
about USD 2,000.
This ensemble perspective overemphasizes the exceptional successes - unlikely individuals that just made a killing in this game by playing it for an hour.
Now’s let’s look at a histogram which will tell us the various levels of wealth of each of the one million people who played this game.
After 60 minutes of play this is what the histogram looks like. Recall that everyone started with an initial wealth of USD100. This is the wealth after 60 minutes of play. Also recall from previous slide, the
average wealth after 60 minutes is about USD 2,000. So, on average, USD 100 will become USD 2,000. A twenty bagger.
But take a look at the histogram. It shows that after 60 minutes, roughly one third of the population is essentially bankrupt: they have less than $1. And most of the players are well below USD 100 - most
people do not make any money in this game.
One of them - the fellow is depicted by green line - ends us about USD 100 million. He and just a handful of other very lucky players pull the average up. And so this average has nothing to do with the
TYPICAL experience.
The histogram of the ensemble perspective after an hour of play where a million people are playing for an hour shows that most people will lose. But some will be huge winners and their “track record”
will pull up the average and give the deceptive impression that this is a good game, on average, but it really isn’t for most people.
And the time perspective, where people will play for a year - every one of them will be broke - even the fellow who had USD 100 mil after an hour - if he continues to play for a year, he too will go broke.
So what you just saw was a “non-ergodic” game. An ergodic system is one when where ensemble perspective and time perspective will have the same outcome. There are many examples of ergodic
systems in physics.
While w will not go there, we will recognize is that the business and investing worlds are non ergodic where ensemble perspective and time perspective give vastly different outcomes.
Another way of illustrating this time perspective is the help of this diagram. Here you have many many worlds - parallel universes. You start in one state of the world up there and time progresses down
on this slide so this world splits into potential futures as you go down. The number of possible worlds increases exponentially. What reality does or time does is that it picks out one trajectory through all
these possibilities. So that's reality - one of those trajectories.
When we're thinking about the time perspective we are averaging along one of those trajectories. When we're thinking about the ensemble perspective, we are averaging across all the parallel worlds, all
the possibilities that could have that could have materialized.
Example: how we compute expected returns. Or how we compute intrinsic business value. When we think about these ideas in investing, we are really taking the ensemble perspective. We use scenario
analysis in our valuation models which requires us to think of various possible future outcomes, we assign probabilities to those scenarios, we do all this number crunching and in the end we derive our
idea of intrinsic business value, or expected returns. But the “expected returns” are like an ensemble average. We don’t take just one trajectory. We talk all of them, we convert them to a single trajectory
- the average trajectory - and from that we make investment decisions.
If the gap between calculated intrinsic business value and stock price is large, we call that as highly attractive idea. We put a lot of money in that idea. Likewise, when we calculate expected returns, and
come up with a large number, we put more money in that idea. So when it comes to investing, we use ensemble perspective to answer two key investment questions: One, is this a good idea? And two,
if this is a good idea, then how much money should I invest into it?
But while our computations envisage multiple scenarios - trajectories, we will not encounter all of these scenarios or trajectories. We will encounter one. And if it turns out to be one which is not to our
liking, we cannot go back in time and access another trajectory. If we end up with a long losing streak, we will be out of the game.
So sequence matters.
“Sequence matters. If you wash your pants, then
dry them, and then wear them you get different
results than if you dry your pants, then wash them,
and then wear them.”
–Alex Hardy
https://twitter.com/CantHardyWait/status/1063908990227226625
If you lose a lot of your money, then it’s very hard to come back. I am not referring to quotational losses where there is no value impairment. Rather, I am referring to permanent impairments in either
earnings or the earnings multiple (for example because of governance issues)…
“Six people playing Russian Roulette once each is
not the same as one person playing it six times.”
–Naval Ravikant
https://twitter.com/naval/status/1051574416260268033
https://medium.com/incerto/the-logic-of-risk-taking-107bf41029d3
This is from The Logic of Risk taking essay by Nassim Taleb which everyone should read. Actually you should ready ANYTHING Taleb writes.
Anyone wants to tell me why, in a good game, in a favorable game, in the long run, everyone goes broke?
Answer: They out 100% of their money in the game every time. And all it takes a long streak of tails - each of which would have costed them 40% of their money - to eventually take them out of the
game.
Ok, here is another way to think about this. I do this in my class. Here are some slides from a class lecture
Let Us Play A Game
I toss a coin
I toss a coin
I toss a coin
Nassim Taleb
It Is Irrational To Separate Risk
Taking From The Risk Management
Of Ruin
Nassim Taleb
So the game is all about position sizing. It’s about concentration of risk - a risk that can take you back to zero or not far from zero or cause major harm - from where it’s hard to come back.
The Game
I toss a coin
I toss a coin
REASON 1
I toss a coin
REASON 2
No CHANCE OF WIPEOUT
Because your net worth is Rs 100 million. And you can afford to lose Rs 1 million (which is just 1% of your net worth) in a favorable bet.
Another question: Does it have to be a wipeout risk that should make you walk away? What about losing 80% of your money?
So, wipeout is not the right word. What’s the right word. Unacceptable Outcome
A Game
I toss a coin
REASON 2
No CHANCE OF AN UNACCEPTABLE
OUTCOME
https://medium.com/incerto/the-logic-of-risk-taking-107bf41029d3
If you lose all your money, or a large part of your money, there is no coming back anymore.
And the one thing that takes people out of the game or substantially out of the is a large position size in a just a few bets gone wrong. So position sizing really matters.
Non Ergodicity in Business
There are plenty of people who indulge in mathematically un-intelligent behavior that, when measured against a time perspective virtually guarantees permanent impairment of capital.
To my students at MDI, I explain this idea with the help of a terrific example given by Buffett.
Buffett: Consider the odds of throwing a 12 with a pair of dice — 1 out of
36. or a 2.8% chance. Now assume that the dice will be thrown once a year;
that you agree to pay $50 million if a 12 appears; and that for “insuring” this
risk you take in an annual “premium” of $1 million.
This is an example of stupid behavior. But what does it do for the decision maker?
Nevertheless, you could go along for years thinking you were making
money — indeed, easy money. There is actually a 75.4% probability that
you would go for a decade without paying out a dime. Eventually, however,
you would go broke.
The fellow who accepts this risk could easily deliver consistent “ solid earnings growth” for ten years in a row as the probability of not landing two sixes over a 10-year period is 75.4%.
And the probability of not landing 12 for 15 years in a row is 0.972^15 = 65%. For 15 long years, year after year, he will collect the premium and not pay out any claim and look like a hero. And then one
day, he will blow up (time perspective again).
If You Incur A Tiny Probability Of
Ruin As A One Off Risk, Survive It,
And Then Do It Again And Again
You Will Eventually Go Bust With
Probability One Hundred Percent
Nassim Taleb
In IIFL, I know there is a spinoff but even after accounting for that, the value destruction has been significant.
Risk aggregation - for example through exposure to real estate developers or large corporate loans (concentrated bets) to dubious credits.
Actually I am quite amazed at the way positing sizing is usually described in leveraged financial companies here in India. Typically a company will that that our exposure to xyz (some toxic waste) is less
than 30% of assets. But in a leveraged capital structure, where equity is 10% of assets, this means that if 50% of the exposure turns bad, then ALL of the equity is gone.
To my mind, and I have seen several instances, Buffett NEVER describes exposure to some risky venture in terms of percentage of assets. Rather he focuses on the risk that matters to HIM - losing his
company’s NET WORTH or a significant part of its net worth. He uses percentage of net worth of Berkshire Hathaway top describe exposure. He also uses terms like “remote loss scenariois” or “worst
case scenarios” to determine the real exposure and that exposure is described in terms of NET WORTH and not assets.
In some leveraged financial companies in India, I found, to my horror that more than 100% of net worth is represented by loans given to troubled borrowers IN THE SAME INDUSTRY! That, in my mind,
is not just risk aggregation, it’s also reckless behavior and complete disregard of prudent risk management practices.
What happens to the person who refuses to play this game. He will live. But will be not be famous. Rather, he will see some reckless gambler become much richer than him. But he will also know that it
is just a matter of time…
For him, the philosophy is: Survival is the key… It’s not a strategy that’s followed by a lot of people. To practice it, you have to give up FOMO and be willing to look foolish, even though you have acted
intelligently. You have to be willing to underperform other, reckless business managers. I mean just look around the world of leveraged financial companies right now. Who are the survivors? And who are
the losers? And why did the survivors survive? By not participating in the dumb behaviour of others.
Paradoxically they are anti-fragile. They can raise money when others are finding it hard or expensive to do so. And they can take market share in segments being vacated by the fragile ones. Anti-
Fragility is not that uncommon as you would expect if you read Taleb’s book. In some industries, just being “not dumb” is equivalent to being anti-fragile.
“They limit the business they accept in a manner
that guarantees they will suffer no aggregation of
losses from a single event or from related events
that will threaten their solvency. They ceaselessly
search for possible correlation among seemingly-
unrelated risks.”
–Warren Buffett, Principles of Insurance Underwriting
In this context I want to say that diversified conglomerates get a bad rap for the he wrong reason. They tend to sell at valuations which are less than their break up value not because the reason to
diversify is inherently wrong. It isn’t. Creating a diverse source of earnings in a single business entity is very desirable.
The real reason why conglomerates get a bad rap in terms of conglomerate discounts is because of capital misallocation - the tendency to squander capital. But there are clearly situations - and
Berkshire Hathaway is an example of one - where diversity of earnings were created without any significant misallocation of capital.
“They limit the business they accept in a manner
that guarantees they will suffer no aggregation of
losses from a single event or from related events
that will threaten their solvency. They ceaselessly
search for possible correlation among seemingly-
unrelated risks.”
–Warren Buffett, Principles of Insurance Underwriting
Great managers work towards reducing fragility. While lost ones go “all in” when they see something profitable even though there is risk aggregation happening. And then, one day, they blow up. Just
like in the game we encountered earlier.
Great managers reduce dependence on a single variable - dependence on handful of customers, a handful of vendors, they reduce plant concentration risk, they go and buy brands they are are
licensees of, they avoid asset liability mismatches, they avoid mismatches between input and output prices. They just recognize sources of fragility in their business models and one by one, they
eliminate it.
The cowboys of the business world on the other hand back up the truck on things they are super confident about. They get into auctions and buy assets at ridiculous prices with borrowed money in
foreign currency’. They find a line of business which is making a lot of money right now but is very risky and they just can’t resist the temptation and they go “all in.” With predictable consequences.
“Time is the best killer.”
–Agatha Christie
Non Ergodicity in investing
Some of you have highly concentrated portfolios. I can tell you that your portfolios are accidents waiting to happen. You are playing with fire and you don’t know it. Time will
Do not overdo on Fisher. And even when Buffett said that if you have a harem of 40 women, you’ll never get to know any of them very well, he runs one of the most diversified conglomerates in the
world.
If the four most important dangerous in investing are “this time it’s different,” and the three most important words in investing are “margin of safety,” then I would submit that the two most important
words in investing are…
“Shit Happens”
–Unknown
Life is full of unpredictable events. The phrase is an acknowledgment that bad things happen to people seemingly for no particular reason.
“Condoms aren’t completely safe. My friend was
wearing one but he was hit by a bus.”
–Robert Rubin
You run a wonderful business and suddenly there are allegations that one of your directors was involved in something dubious and the stock tanks 50%. And the multiple tanks because of governance
concerns and the belief that there is not just one cockroach in the kitchen. You run a thermal power plant with dependance on coal imported from Indonesia and suddenly the Indonesian government,
jacks up the price of coal and you have fixed price contracts for sale of power. You own a large position in a business with 5 customers and one of them goes bankrupt. And so on..
“Condoms aren’t completely safe. My friend was
wearing one but he was hit by a bus.”
–Robert Rubin
Your only protection is diversification. Granted that the need of diversification is more in risk arb and commodity businesses and statistical bargains as opposed to higher quality businesses that does
not mean overused positions in those business will never cause your portfolio grave har. And once gave harm has been caused, it’s very difficult to get back.
Please move away from 5 stock portfolios and 10 stock portfolios. This is true even of concentrated strategy has made you a lot of money. It’s ESPECIALLY true if such a strategy has made you a lot of
money. Because by now you will be puffed up.
–Peter Bernstein
https://jasonzweig.com/a-long-chat-with-peter-l-bernstein/
The skills required to make a lot of money are not the same as the skills required to protect it and to grow it judiciously. Grow up. Buffett too did. Recall that he put 45% of his AUM in a single stock -
Amex, when he was young. Will he ever do anything like that again? I don’t think so.
“Shit Happens”
–Unknown
And when I talk about over concentration, I am not referring to a single stock position. Hell no!
I am referring to buying too many financials, or too many midcaps, or too many pharma companies to too many of anything (including high P/E stocks which are vulnerable to a slowdown) where there is
aggregation of risk. Why? Because in each of those situations, there is risk aggregation taking place.
The art of wealth protection costs money in sacrificed returns from seemingly lucrative opportunities that have a lot of risk aggregation, which over time, can take you out of the game.
“How many of your successful investments
occurred in the timeframe you originally predicted?
How many times do you ever remember saying,
“Well that happened a lot sooner than I thought?”
–Ian Cassel
Even if you are right about the QUANTUM of cash flows, if you turn out to be overconfident about the TIMING of those cash flows, the returns that you will make could easily be a fraction of what you
thought you would make.
And if you have a large position size in such a situation, you may not lose money in the long run in accounting terms, but your overconfidence could easily lead to a significant underperformance and for
many in the money management business that’s indistinguishable from failure.
“There are old traders and there are bold traders,
but there are no old, bold traders.”
–Ed Seykota
“My largest positions aren’t the ones I think I’m
going to make the most money from. My largest
positions are the ones where I don’t think I’m going
to lose money.”
–Joel Greenblatt
This is logical. We have a tendency to focus on the UPSIDE. We estimate per-share intrinsic business value. We estimate expected returns. And we size positions based on the discount to fair value or
expected returns.
But some things are STRUCTURALLY more vulnerable than others - they have significant downside. The ones that use a lot of borrowed money. The ones in commodity businesses where competition is
extreme and there is no cost advantage. The ones which are tiny. The ones which have mismatches in assets and liabilities or input and output prices or are over-dependent on a handful of customers or
vendors or a single product or technology. The ones which do not have “diversity of earnings” in other words. Those are the ones, that if you buy them, must have a small size in your portfolio.
And please do not get carried away by Kelly formula. Many people have got badly burned by it. Financial markets are not like casinos where all scenarios are known and odds can be perfectly
calculated. If you size your positions based on your estimates of margin of safety our expected returns using ensemble perspective, then you are positioning yourself for a double whammy. You will
encounter only ONE of those trajectories that you thought of. And your overconfidence derived from the ensemble perspective will lead to a too large a position size. And you could end up with a “shit
happens” trajectory with a too large a position size.
https://jasonzweig.com/a-long-chat-with-peter-l-bernstein/
And for those of you with concentrated portfolios and who think diversification is just protection against ignorance and that it’s just a risk reduction strategy, here’s one slide, the last one, where I will take
one last shot to hopefully persuade you about the key message in this talk…
–Perter Bernstein
https://jasonzweig.com/a-long-chat-with-peter-l-bernstein/
If you never look beyond what you own in your concentrated portfolio, and you over love what you own, then you will never have the money and the motivation to look OUTSIDE your portfolio for
opportunities which will give you exposure to ideas that have the potential to create a lot of wealth for you while at the same time help you stay in the game…
Thank You