ergodicity
Just finished 'Skin in the Game' by the excellent Nassim Nicholas Taleb. The book ends with the most important chapter on Ergodicity and the concept of systems being 'ergodic' or 'non-ergodic'.
Ergodicity can be a tricky subject to break down but there are two metaphors that help the understanding.
🔫 Firstly, Russian Roulette. There are six chambers but only one round in the revolver. The odds of blowing your brains out are 16.7% on the first pull. Of course, if you pull the trigger another 5 times, the odds increase to....100% (or certain death. Either way, it’s not a good outcome). Now consider if you played Russian Roulette one hundred times versus a hundred people playing it once. Odds are different and are expressed through 'ensemble' and 'time' or in plain language, the difference between a repeated action by a single person versus the same action undertaken by a group.
If a system has the same outcomes for a group as it does for an individual, then it is said to be 'ergodic'. If outcomes differ in the system, it is said to be 'non-ergodic'.
The stock market is non-ergodic.
⛷ Second example comes from the book titled 'Ergodicity' by Luca Dellanna. His cousin was a promising competitive skier. One day he skied too fast, fell and broke his leg, thus ending his career. Therefore, it isn't necessarily the fastest skier who wins the race but the fastest skier who finishes! Dellanna states "The long term isn’t made of a succession of short terms, each optimizable in a vacuum. Instead, payoffs change as time horizons change."
Performance is subordinate to survival.
✍ Surviving and being resilient is more important than chasing short term success. The old saying goes "history is written by the winners" but it should actually state "history is written by the survivors!"
Turning this to investment and linking it to behavioral psychology, Survivorship bias’ is a pitfall in investment analysis that occurs when surviving or successful investments are considered when evaluating performance. We witness this in the calculations of the indices we measure against and when stacking up funds against the peer group averages.
An investor who takes undue risks and suffers permanent loss of capital is out of the game. There is no way back from a ‘game over’ scenario no matter how good he/she thinks they are.
How to help mitigate?
📊 The next time a fund manager is showing you the performance calculations, review them closely to see what they are actually presenting. If they are comparing against peer group averages, know that this will be rife with surviving winners (of which they will be too) and try to ensure the performance is benchmarked against the actual index stated in their prospectus. Further, you can de-emphasize performance and focus on how clear, repeatable and robust their investment process is. You don’t want a fund manager playing Russian Roulette with investments.
