Solely Analytical Methods Are Doomed To Failure

The Wall Street Journal has an article this morning entitled, “Economists’ Grail: A Post-Crash Model.”   The article demonstrates aptly exactly why I wrote my book, The Intuitive Investor: A Radical Guide for Manifesting Wealth.

You see it all comes down to this:

There is no such thing as a future fact.  Facts by definition are things that have already happened…in the past.  Yet investing is an activity that unfolds in the future.  So facts and investing are actually at cross purposes from one another.

But “[f]or decades, most economists, including the world’s most powerful central bankers, have supposed that people are rational enough, and the working of markets smooth enough, that the whole economy can be reduced to a handful of equations.  They assemble the equations into mathematical models that attempt to mimic the behavior of the economy,” says the Wall Street Journal.  I can attest as the retired co-portfolio manager of the Davis Appreciation & Income fund that this is how almost all investors, professional and amateur alike, go about making their decisions.

The WSJ continues: “In the wake of a financial crisis and punishing recession that the models failed to capture, a growing number of economists are beginning to question the intellectual foundations on which the models are built.”

Unfortunately, even the questioning is still rooted in a paradigm that is incorrect.  Note “the intellectual foundations” verbiage in the preceding quote.  The problem is that researchers are looking for a solution within the bounds of the analytical left-brain, which happens to be the source of the problem to begin with!

Human beings are well equipped to deal with the organic, multi-dimensional, future-oriented problems that confront every investment decision maker.  Here I am speaking about the right-brain.

Our right brains thrive in an organic, multi-dimensional, hyper-complex, future-oriented environment.  Unfortunately, the foundations of our learning traditions in the western world have emphasized analytical methods for far too long and to such a degree that the right-brain is ignored at best, and ridiculed at worst.

Why are we so absolutely rooted in this way of thinking?  It is because long ago the bedrock, metaphysical, underpinnings of western thinking stopped being questioned.  Here I am talking about the assumption that the only things that are acknowledged as real are those things that are endlessly replicable.

What about the unpredictable?  What about the truly exceptional?  What about those moments when everything changes all at once?  In the world of economics and finance those things that cannot be described mathematically and that are not predictable are either rationalized away, or are ignored entirely.

I am not the only one who recognizes and has written about these massive shortcomings.  Here is a quote from James Gleick’s book Chaos: Making a New Science, that I also quote in my book The Intuitive Investor:

“The [mathematically] solvable systems are the ones shown in textbooks.  They behave.  Confronted with a non-linear system, scientists would have to substitute linear approximations or find some other uncertain backdoor approach…When people stumbled across such things – and people did – all their training argued for dismissing them as aberrations.  Only a few were able to remember that the solvable, orderly, linear systems were the aberrations.”

Or, if you prefer, from the Wall Street Journal’s article, a quote from leading chaos-theory-as-applied-to-the-financial-markets researcher Doyne Farmer of the Santa Fe Institute:

“A typical [model]…consists of anywhere from a few to dozens of interlinked equations, which must agree before the model can spit out a solution.  If the equations get too complex, or if there are too many elements, the models have a hard time finding the point where all the [investors’] preferences meet.

“To keep things simple, economists leave out large chunks of reality.”

Look at the gap in time between James Gleick’s statement of 1987 and Doyne Farmer’s talking about the same thing 23 years later in the Wall Street Journal; this is stunning!  Despite the obvious shortcomings of analytical models people continue to look for solutions in the same, limited space.  There are no needles in that haystack; I know because I looked my entire life for them, too; that is, until I realized that solely analytical methods are doomed to failure.

So what sorts of solutions are being proposed even by those who understand the shortcomings of analytical methods?  From Mr. Farmer himself, “…a proper agent-based model could take years to build…”  In other words, let’s just increase the complexity of the mathematical models.  Let’s just look for a solution in the same ground that we have already tread.  How do you make a super complex model like this work?

“The tough part is coming up with rules that bear some relation to reality…Writing better rules for human behavior will require researchers to dig deeper into the human psyche.”  This is like pushing a string.

Who determines the inputs that are worth putting into the computer model?  A human-being.  Who programs the computer that might evaluate which inputs are replicable and that are core to understanding human beings?  That’s right, a human being.  Who determines the methods that are appropriate to evaluate human behavior?  Again, it is a human being.  Underlying all of the smoke and mirrors of analytical methods, no matter how complex, are human beings and human choices about what makes sense in terms of an evaluation or a method.

Because mathematics is invented by human beings to serve those western world metaphysical postulates – only that which is replicable is real – mathematics is, by definition, a subset of the human being.  That is, math is within the bounds of the human-being.  Therefore, it is less than a human being’s capabilities.

The only reason that math is believed as underpinning nature and natural functions, and therefore as the only thing that is real, is because we have created it as a tool to describe the only thing we have chosen to believe in: a linear reality.  This is recursive logic.  We choose to believe math underlies reality, therefore we only pay attention to those things described by math.  All the while there is that inescapable brush with reality: math, by some estimates, describes well less than half of actual reality.

Just as the analytical world’s advocates were on the verge of recognizing the hidden absurdity of their assumptions about reality, then rode in on a white horse an armored champion: behavioral finance.  Behavioral finance is genius.  It highlights the limitations of the right brain.  Therefore, we can hold on to our analytical methods and ignore the assumptions underlying our choices.

Unfortunately though, behavioral finance can only demonstrate the limitations of the right brain when there is in fact, a known and quantifiable analytical answer.  But there is no such thing as a future fact.  Investing unfolds in the future.  So we are stuck with the same pickle as before.

But not everyone is drinking from the same punch bowl.  From the Wall Street Journal’s article is this lovely quote from an economist, Roman Frydman:

“The main flaw in the dominant models, he says, is the same feature that makes them so attractive to policy makers: Their ability to make precise predictions.  To generate their predictions, the models assume that people, firms and other players always make decisions in the same way.  The players must also share the same belief about the exact probabilities of various outcomes, such as a rise in car prices or tax rates.

” ‘It’s like socialist planning,’ says Mr. Frydman.  ‘If we really knew that much, we could have Communism and God knows what.’ Capitalism works better than other systems, he says, because it lets people disagree about the future and profit from their insights – rational behavior that models don’t accommodate.

“Mr. Frydman doesn’t offer a better way to make predictions.  Rather, he believes economists and policy makers must come to terms with the limits of their knowledge.”  [Or their underlying assumptions.]

Amen!  Or maybe not.

While Roman Frydman recognizes the limitations, his policy prescription is simply to change the laws/regulations that control the game.  His strategy is basically to limit the realm of possible choices in the real world to those that fall within the bounds of statistical methods to predict them.  That is, he wants to eliminate the “fat tails” or extreme, unpredictable swings of the real world.  Effectively, he wants to legislate away reality and all of its non-linear sloppiness.  Wow!

Assuming that this is absurd then begs the question: what can be done?

1. Light must be allowed to shine on the underlying metaphysical assumptions of western thinking.  Namely: only that which is forever replicable and describable by mathematics is real.
2. We must acknowledge that we cannot look for a solution within the same methodology that has created the problem, mathematics.
3. We need to recognize that math is a subset of human capability and only capable of describing well that portion of human beings and our world that is predictable.
4. We must acknowledge that the human being has a tremendous capability to assess the multi-dimensional, unpredictable world; that is, our right brains.
5. We must enter this space without our usual mathematical tools and instead, enter it embodying the true nature of the scientist: an explorer of the uncharted.

So little work has been done to codify and systematize the right-brain’s abilities that most researchers and practitioners have abandoned work there.  But the right-brain does respond to method.  Most importantly, investment decisions made using its powers of creativity and intuition are quantifiably successful.

I hold up my professional investment career as an example.  I hold up my prediction of a global financial meltdown on October 21, 2004 as an example.  I hold up my calling the March 9, 2009 market low on this blog on March 12, 2009 as an example.  Each of these things was unpredictable by mathematics, but was predictable by the creators of mathematics, a human being.  But the methods were creative and intuitive, not mathematical.

What is lacking in this super cutting-edge, boundary-busting realm is interest, patience, and language to describe the phenomena of the right-brain.  That is exactly what The Intuitive Investor: A Radical Guide for Manifesting Wealth does.  It argues that a balance between analysis and judgment are the keys to effective decision making.

Jason