Stephen Jay Gould on investing

Evolution is competition and adaptation in slow motion.  Really slow motion.  We can never be geologically relevant.  But we can speed this up and compress the time frame to look at companies.  Companies compete in an environment with tons of variation and randomness.  Sometimes there is the advantage of backwardness.  The disappearance of a dominant entity can say more about the increasing capability of weaker entities than a failure at the dominant one.  Looking at evolution and punctuated equilibrium can be an interesting mental model for investors.

Stephen Jay Gould, the scientist that I am aware of being credited with punctuated equilibrium, wrote a book I like called Full House.  I’ve read some articles on SJG criticizing his contribution to the scientific field, but I figure this falls under the broad category of assembling a latticework of mental models.  Full House is a more science-oriented version of The Black Swan.  Gould does explicitly denounce Platonic thinking (like Taleb) and uses the drunkard’s walk as part of his reasoning in explaining it.

The crux of Gould’s argument is that people who believe evolution happens by virtue of some logical progression misunderstand variation and the randomness of the world.  It is much too random to be the product of a Platonic deductive reasoning.  To a man with a hammer everything looks like a nail.  Gould uses evolution as a demonstration of this cognitive flaw since that is where he sees it.  Taleb points this out in financial markets and the broader world of practice.  I like Taleb’s example of trying to figure out what an ice cube looked like before it turned into a puddle as an illustration of the same idea. 

Gould uses the drunkard’s walk to demonstrate how humans evolved.  How this ties into statistics is because the human species represents the right tail on the distribution of variations of organisms.  When people attribute human complexity to some idea of progression or complexity from bacteria to plant to animal to human, they ignore that the greatest variation lies in species of bacteria.  All of the variation represents equal outcomes of evolution in terms of “progress.”  His point in Full House is that we too selectively interpret this data point to suit our ends rather than place it in the proper evolutionary context of randomness.  We’re just one outcome of many and we don't fully appreciate it.

In an interview with Gould, modeling evolution on computers could just be switched out for the stock market:

How do you view the new science of modeling life processes like evolution on computers? You're talking to a man who still writes on an upright typewriter. Artificial life I find interesting, I've read a little of the literature. But I don't know how much it's going to teach us about actual life. It does allow you to iterate a set of simple rules and see what happens. That's not how the world out there works, but that's an interesting thing to do. Natural selection in its pure algorithmic form doesn't happen out there either, but you can do it on the computer. I think it's a very valuable approach. It would be a danger only if people thought that's how the world worked.

Gould discusses a nice range of topics that are worth exploring throughout his career.  The difference between theory and practice is that theories don't always reflect how the world works.  In one of his early papers he discusses the flaw in thinking of evolution as an optimal adaptation, the byproduct of failing to appreciate the randomness.  People were interpreting the complexity of human beings as fully evolved out of necessity.  It's just not how the world works.

In this paper, The spandrels of San Marco and the Panglossian paradigm: a critique of the adaptationist programme, Gould and another scientist, refute the idea of natural selection as resulting in optimal outcomes.  It’s the same idea as Full House presented a little differently and free online.  The Panglossian paradigm is assuming that our noses have evolved to hold eyeglasses taken from Pangloss in Candide.  Gould compares this type of outlook on evolution to the spandrels of San Marco.  A spandrel is a “random” architectural component that emerged to support domes but then achieved a certain artistic relevance in the overall structure.  People made use of it, but people did not include it in the overall architecture to make use of them.

There has been criticism of Gould’s characterization of spandrels and his overall contribution to evolutionary biology.  I can’t really judge the validity of them.  I’m curious about investing.  These ideas are relevant.  In Full House, Gould makes the direct charge that Platonic linear thinking is a flawed method for analyzing such a random event as evolution.  The Black Swan is a more relevant treatise in regards to investing on this type of flawed thinking, but sometimes removing the immediate noise of applying an idea to financial markets can help illuminate them.

What are some other ideas that strike me as useful applications of Gould’s thinking to financial markets?  Well it boils down to people wanting to create narratives for why things are the way they are.  Only because it is quite contrarian to the normally touted reasons for the appreciation in gold prices, Krugman makes the case that the price rise is a deflationary indicator driven by falling interest rates signaling deflation.  I like it.  It makes sense.  I'm not going to do anything about it, but it's an entertaining idea to entertain.  In doing this though, you can appreciate how difficult it is to really apply deductive reasoning to what happens in the real world.

Applying this type of thinking to macroeconomics is exactly what I would counsel against, but it is worth learning from.  We really won’t know who is right for several years, if not decades.   A macro issue where people are focusing on the wrong data point is comparing the US economy to Japan.  Richard Koo is a Japanese economist who is claiming that the US is facing exactly what Japan faces.  Below is a short video that outlines his thinking.  It’s not bad if you are unfamiliar with the argument.

How do you avoid this type of thinking?  How do you separate the forest from the tree or the spandrel from the dome?  One person who has responded in the proper way to this idea of the US equaling Japan 15 years ago is David Merkel.  He just lists the similarities and differences.  

There are some key points that differ.  Focusing on ZIRP and deficit spending is retroactively applying the effect to a cause – like assuming human evolution stemmed from a notion of progress – rather than acknowledging the huge amount of variation in causes and effects.  How do you separate the spandrel from the dome?  Things like ZIRP, deficit spending, or demographics.  Are they spandrels or domes?  Merkel brings up the issue of the aftermath of overconsumption versus over production.  This is more likely the dome equivalent since that is the essence of what is being dealt with and the ZIRP or demographics are just the spandrels that stem from the existence of over consumption or production.

This may boil down to personal capacity, but I find the ability to make macro calls difficult.  I could feel confident saying the US will not look like Japan based on the grounds that Koo is really just a man with a hammer.  It's hard to take anything away from this and apply it to actually investing.  Merkel doesn't prove anything as much as he disproves the thesis that the US is following in Japan's foot steps.  But many people say that investing is a negative action - inaction - since what you don't do is more important than what you do do.

In a similar vein to the discussion of Japan's economy and our misguided fixation on certain outcomes (humans, balance sheet recessions), Charlie Munger brought up a differing explanation to Japan's economic malaise with a mental model that closely resembles Gould's.  According to the Innoculated Investor notes from the 2011 Wesco meeting:

Next, Charlie provided an explanation of Japan’s economic malaise that is not commonly cited.  Japan is an export dependent economy. In the late 1980s and 1990s, Japan got huge and credible new competition from China and Korea. They got this because the traditional laws of economics were working well in China and Korea when they adopted something like free market capitalism. The main competitors got more competitive and this impacted Japan substantially. This is an explanation that you never hear. This is why you need to try multiple approaches to solving problems.

Gould discusses a similar example in Full House with the disappearance of the .400 hitter in baseball.  His claim is that this is the result of an overall improvement in excellence and shouldn't be interpreted as a sign of degrading quality in baseball.  I wasn't aware that people claimed the disappearance of the .400 hitter meant this, but in the book he quotes people who apparently claim so.  What's important is to think deeply about how people become fixated on the spandrels instead of the domes.

All of this does apply to thinking about specific businesses in an intelligent and businesslike manner.  It's important to figure out if the perspective you adopt to look at a data point is really reflecting the reality behind it.  I'm going to stop here and write a separate post on what I think are example and methods for applying this to stock selection.