Why Understanding Ergodicity Is Critical To Your Long Term Survival

How can we achieve a consistency of outcomes against the certainty of extreme variations?

Definition

A system or process is ergodic if:

1. The outcome for the individual is the same as for the group, AND IF
2. The outcome for the individual and the group remains the same over time. i.e. the outcome is universally the same.
   

An ergodic system or process always has these qualities, it:

1. Is not path-dependent i.e. what has gone before has no bearing on what happens in future.
2. Has no dependencies or variables i.e. there is nothing that can affect the outcome.
3. Is independent of conditions i.e. the outcome will be the same regardless of the circumstances.

EXAMPLE OF ERGODIC PROCESS WITH 100% CONSISTENCY OF OUTCOME

A simple and ridiculous example of an ergodic process involving the law of gravity

If an individual jumps out of a plane without a parachute, he/she will not survive.

If a group jumps out of a plane without parachutes, they will will not survive.

If another individual and group are stupid enough to repeat this at multple points in the future they too will will not survive.

There are no dependencies, variables or conditions.

There is a 100% consistency in the outcome, for the individual, for the group, and at all points in time.

This is an ergodic process.

EXAMPLE OF A NON-ERGODIC PROCESS WITH ZERO CONSISTENCY OF OUTCOME

Average rates of return - are wrongly presented as an ergodic process offering consistency of return to the individual investor

Why is it that the world of investment and financial services invariably cites an average rate of return over a fixed period of time as a criteria and metric for making an investment decision?

Suppose that the cited average rate of return is 8% per year over the past 20 years.

Let's apply the tests.

1. Does every individual achieve an 8% annnual rate of return the same as the whole group of investors does?
   
2. Does the individual achieve this 8% return every year for 20 years?
3. Does the group achieve this 8% return every year for 20 years?

The answer in each case is "No!".

Why? Because the stated annual rate of return is an average and thus includes an incredibly wide range of outcomes for all individuals [i.e. extreme variations of individual outcomes within the group]  and the sequence and timing of those individual outcomes is unknown.

An average group rate of return is meaningless and irrelevant to the expectations and experience of any individual investor and therefore should not be offered or taken as basis for making an investment decision....and yet it is.... it is not only wrong but it is also misleading!

There is zero consistency of outcome for the individual investor.

This is not an ergodic process.

POINT OF INFORMATION 1.

The fallacy of averages

The average of a range of numbers is the total of those numbers added together divided by the count of items in that range. In the example above the average is $498,000.

The median of a set of numbers is that figure where half of the numbers are lower, and half of the numbers are higher. In the example above the median is $105,000.

The wider the range of numbers the greater will be the disparity between the average and the median.

For example, the average income in the US in 2019 was $69k the median income was $36k.

The range of extreme variation was from below $15k [bottom 10%] to $600k+ [top 1%]

The median is a better indicator of the likely outcome for the majority, BUT the outcome for the individual is subject to the probability of extreme variation.

POINT OF INFORMATION 2.

Normal Distribution vs Power-Law Distribution

This describes how the certainty of extreme variations is ignored by those who rule us because their basic assumptions are wrong - they are using the wrong model!

In a normal distribution -  commonly known as a bell curve - the outcome for the vast majority of the group clusters at or around the mid-point or average.

There will be outcomes experienced by small number of individuals at both ends of the outcome spectrum that will be much higher or lower than the average.

This normal distribution/bell curve is the model most frequently [and wrongly] assumed in the modelling of governments, economists, businesses and investment advisors.

They assume a consistency of outcome and traditionally regard the possibility of extreme outcomes - technically "tail risk" - as irrational i.e. it is ignored.

A Power-Law - commonly known as the Fat Tail -  describes a relationship between two things in which a change in one thing can lead to a large change in the other, regardless of the initial quantities.

Statistically it describes a range of variations from the mean that can be very large.

It also describes a rate of growth that is exponential i.e. the speed of the change is as important as the growth - it gets bigger faster!

This is a non-ergodic process where there is certainty of an extreme variation.

The obvious question that arises is what causes or triggers these extreme events to occur and to take place so unexpectedly and so quickly?  

Often we may never know what fully causes these things to happen but the process of what happens can be described as an inflection point.

Inflection points occur when there is build up of forces, a critical mass, that lead to a spontaneous and often irreversible change of direction and an unstoppable effect or change takes place.

Example of inflection points are:

• In business the point at which an issue, an idea, a concept, a product, crosses a certain threshold and achieves significant momentum that is triggered by some small factor or change.
• In medicine, and taking the covid-19 pandemic as a good example, the point at which a minor development precipitates a crisis, such as every infected person brings us closer to the tipping point, when the outbreak becomes an epidemic.
• In physics, the point at which an object is no longer balanced, and the addition of a small amount of weight causes it to topple.
• In relationships, the point at which the accumulation of a number of negative behaviours and factors reaches a point of no return and one party terminates the relationship.

These tipping points can lead to a negative event that is rare, unpredictable and has devastating consequences that can destroy wealth, health and peace of mind... and lives.

The pandemic, the Russian-Ukraine war, the 2008 banking crisis, the impending major financial correction/disaster and potential collapse of fiat currency, and the eventual and probable devastating war with China over natural resources that has yet to happen, could all fall into this category in so far that few foresaw these events.

The reason why our leaders and rulers make this fundamental mistake and use the wrong model is because they only focus on what they can see and what they can measure - and ignore the rest.

In the interconnected world we live in it is these hidden - and ignored - factors that will contribute to these extreme outcomes.

They are hidden because they are intangible and not easily measurable.

They are hidden because the time spans and sequencing of these outcomes are random.

The risks they are carrying are dismissed as "irrational".

This fundamental error by our rulers and leaders is what Nassim Taleb refers to as being:

"FOOLED BY RANDOMNESS!"

Definition

A system or process is non-ergodic where:

1. There is a possibility of extreme variation of outcome which can lead to a total wipe-out and ruin, or a massive gain, AND
   
2. Over time this becomes a probability, AND
3. Over the passage of more time it becomes an occurrence.
   

A non-ergodic system or process always has these qualities:

1. It is path-dependent i.e. history matters, the longer it continues the higher the probability of extreme variation.
   
2. Past probabilities do not apply to future outcomes.
   
3. At some unknown and indeterminate point in the future there is a stop in the system or process which results in ruin or massive gain.
   

The ruin is inevitable but its mitigation or transmutation into massive gain is entirely dependent on preparation.

Nassim Taleb

HOW TO MITIGATE THE EFFECTS OF EXTREME VARIATION

[1] Insurance

This is so obvious that it shouldn't need explaining.

However, it does amaze me how many people I know who are not insured or under-insured for major life-changing extreme variations on the basis that "it won't happen to me" or "I can't afford it"....

[2] Contra-Investment

I know a man who has investments in the hospitality industry and he owns a number of bars and restaurants, and to mitigate his risks he has invested in self-catering accommodation and the take-away/take-out sector and he has also recently launched a consultancy service and has developed an online business for home-cooking.

He is well positioned to succeed in one or more of those businesses regardless of economic circumstances.

I call this contra-investment - rather than diversification - because you invest your time, energy and resources in activities that are the 180 degree opposite of your core activity, business or main job.

[3] Balanced Diversification

In this scenario you focus 70-80% of your time, energy and resources on your core activity, business or main job, but you invest 20-30% of your time, energy and resources into several quite different areas of activity or projects, that interest you.

[4] Live A Life Of Antifragility

This starts with an attitude to life that embraces uncertainty and understands Antifragile - How To Benefit From Disorder and practices living an antifragile life.

This is all about creating options and slack in your life and having Plans B, C & D and being flexible. Please checkout the links above and the extensive resources on those pages.

HOW TO POSITION YOURSELF FOR MAJOR OPPORTUNITY ARISING FROM EXTREME VARIATION

An example of an ergodic approach that failed and non-ergoic approach that brought massive opportunity and gain

I run a company based in Singapore that specialises in commoditities, and I have a colleague who focused on the semi-refined gold [dore] market with producers in Africa and buyers in the Middle East. 

His approach was 100% ergodic. It was all about the numbers and chasing the deals - the things that were visible and easily measurable, and where he [wrongly] assumed that with the right amount of effort he would get good results.

Over a period of several years I suggested that he build up his knowledge of the sector and focused on a small number of high quality key relationships with producers.

I tried, unsuccessfully, to persuade him to focus on the intangibles and thus build up a reputation as an expert and so attract business. But he wouldn't listen. He used to say to me:

"It's all about the deal Stephen...the deal..."

Fast forward a couple of years and post the pandemic and he now has no business and no money.

In contrast, I have another colleague who works in the fuel sector and he took a totally different and non-ergodic approach.

He focused on deep learning of the business, he sought hidden value in the intangibles of the business and treated every opportunity and countless failures all as learning experiences to build reputation and a knowledge base.

He built deep and strong relationship with producers and narrowed his focus to crude oil and liquid natural gas [LNG] figuring that at some point in the business cycle there would be huge demand for these products.

Of course with recent events in Ukraine and the embargo on Russian fuel this has proved to be a good move as the extreme variations that have hit the fuel market have created massive and extremely lucrative opportunities for him and he is making a lot of money.

The way to position yourself for major opportunity arising from extreme variation is to identify and exploit the unseen margins

I recently wrote an article on this subject, which I commend to you. Here is an indexed key point summary:

How To Benefit From The Unseen Margins - Defining Our Terms

1. Margin - Types: Tangible & Intangible
2. Metrics - Primary and Secondary Currency
3. Visibility - Margin Type + Currency

How To Benefit From The Unseen Margins In An Environment Of Complexity

1. Gaps Between The Map And The Territory
2. Top-Down Over-Simplification
3. Cause And Effect in The Passage Of Time
4. Human Laziness, Need and Greed

5 Key Tips On How To Benefit From The Unseen Margins

1. How Can I add Value To This Person Or This Situation?
2. How Can I Leverage This Situation For Future Advantage?
3. Who Is This Affecting And How Is It Affecting Them?
4. What Are They Measuring, Where Are The Gaps And What Are They Missing?
5. What Is The Bigger Picture Here - Who Stands To Gain/Lose And Why?

Guiding Principles On How To Benefit From The Unseen Margins

1. Understand Your Currencies And The Relationship Between Them
2. Prepare For The Unexpected
3. Work With Probability
4. Play The Long Game [And Be prepared To Pay The Price]

Life is non-linear, which makes the rewards of continued effort disproportionately big, but because progress on the extra mile isn’t clearly visible, most people give up too early.