Michael Mauboussin of Legg Mason is always worth reading. More Than You Know: Finding Financial Wisdom in Unconventional Places (Columbia University Press, 2006) is a collection of essays that flesh out his belief that people should approach problems from a multidisciplinary perspective. Here I’m going to summarize an essay entitled “Chasing Laplace’s Demon: The Role of Cause and Effect in Markets” because it addresses one of my pet peeves.
The stock market, Mauboussin argues, is a complex adaptive system. This means, among other things, that we can’t understand its global properties by analyzing its parts. It also means that “cause and effect defies any simple explanation.” But human beings are wired to find causes for events. When in doubt, we simply make up causes.
The stock market, to use the jargon of complex adaptive systems, is in a state of “self-organized criticality.” As such, “the magnitude of a perturbation within the system (cause) is not always proportionate to its effect. Small perturbations can lead to large outcomes, and vice versa.” (p. 188) To take an example that’s easier to understand than the stock market, a pile of sand, once it gets to a certain height and slope, enters into a self-organized, critical state. Sprinkling a few more grains on the pile may trigger a small or large avalanche. The size of the avalanche is not necessarily linked to the amount of sand added. Analogously, in the stock market a piece of information on one occasion may barely move the market and a very similar piece of information on another occasion may lead to a huge rally or selloff.
But the press is determined to find a cause, however silly, for every stock market move. And investors who buy into their explanations are at risk. First, they may mistake correlation for causality. “In one extreme example, Cal Tech’s David Leinweber found that the single best predictor of the S&P 500 Index’s performance was butter production in Bangladesh.” Although not even a half wit would trade the S&P 500 based on this information, there are more seductive correlations that pose as causes and can entrap traders. Second, investors may succumb to the pitfalls of anchoring, where we accept something that may be irrelevant or arbitrary and use it as a key reference point in making future decisions. (For an interesting experiment on anchoring see Dan Ariely, Predictably Irrational.)
So we’d all do well to tune out the gurus who confidently explain the cause of every flutter in the stock market.