In praise of randomness

In the New Year, annual forecasts bloom like an early spring. I want to get out in front of that crowd with important guidance. Something is going to happen. It is a prediction I make each year and for nearly half a century I have never been wrong.

You may wonder if this kind of punditry is helpful. Let me try to head that off, too.

Gordon Gekko, in the movie Wall Street, is famously quoted as saying “Greed is good,” a line written to make a capitalist look bad. He might have, less alliteratively but more accurately, said “Self-interest is good.”

What use is this in forecasting? There are risk-management analogies. Suppose I said “Random is good”? Your natural reaction might be to recoil in disgust. People don’t like randomness. We want to make accurate predictions. We like to know the outcome before we act. Nice work if you can get it.

A step further into probability theory teaches us that the second flip of a coin has no memory of and is therefore not influenced by the prior flip. This is the purest form of randomness.

An impressive idea in mathematical statistics is the notion of independence. With that purest form of randomness we get independence (the second coin flip is mathematically independent of the first). If I say “Independence is good” your reaction might be positive. The combination of randomness and independence forms the basis for the wisdom of diversification. This idea is not just personal. It scales up to society as a whole.

During the frightening days of mid-September in 2008, as Lehman Brothers collapsed with AIG and GM to follow, government engaged in various bailouts. A friend observed at the time: “The government is taking risk out of the system.” I offered a correction: “They are temporarily taking the consequences of risk out of the system” to emphasize the reality that risk is never completely eliminated.

Since those dark days, through a number of subterfuges and sleight-of-hand maneuvers, government has wired the System together in ways never seen before. This is a simple corruption of otherwise healthy randomness needed in the system. It is a pure anti-diversification play, frustrating risk management naturally in the hands of many independent people each interested in preservation.

Instead, it attempts to concentrate hedging in 535 loons in Washington, half with questionable intentions and the other half with questionable intelligence, all creating perverse incentives with their every move. The consequence is to make forecasting a fool’s errand.

The post-modernist crowd and their youthful electronic progeny in social media will object that humans are not coins; we are all connected. We need a shared memory. Perhaps, but the sad legacy of communal failures casts real doubt on whether “It takes a village.” Why have history if people do not learn from it?

Advanced mathematics offers methods for handling correlation, serial dependence, vector auto-regression and various departures from normality. But they are all contortions of sorts designed to deal with conditions where pure, independent, simple randomness is not available.

For natural connections in physics and biology, these tools can be useful. But the unnatural imposition, by government edict, of dependency among economic variables stretches such methodology to the breaking point. That stretching widens the holes in any safety net, real or perceived. At the breaking point something happens.

We have all our eggs in one basket.

Happy New Year.

Brown is an investor and freelance writer in Alpine.

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