Cosmic Chaos and the Art of Portfolio Management

After reading “A Brief History of Time” many years ago, Stephen Hawking became one of my heroes.  Though written for a general audience, being both a student of history and of finance did not provide me full understanding of even his non-technical version of the cosmological forces as understood in 1988 when published.

I had the good fortune of meeting Stephen Hawking in Pasadena many years ago.   During the summers, Dr. Hawking would arrive at Caltech’s campus to lecture and to meet with professors and students.  As Treasurer, I was responsible for managing the school’s real estate holding and thus was his landlord during his stay.  As with most of us mortals, and even for the immortals, I was awed by his presence.   He demonstrated great fortitude during his battle with ALS which eventually ended his life.   I have thought of him often recently as my own sister-in-law has exhibited similar fortitude while waging a similar battle with ALS.

Inspired by Stephen Hawking, I wrote an opinion piece comparing cosmic chaos with portfolio management.  This earlier version of what I present here appeared in Pensions & Investments in 1992.  My grappling with how chaos impedes the physical and personal impacts of the world around us obviously has been a focus of mine for decades.  When looking at the opinion piece here, the Reader might consider using his/her imagination by substituting “territorial markets” for “financial, capital or investment markets”, and  “political or polity” for “economic or economy”.

“Small departures from uniform density in the early universe caused the formation first of the galaxies, then of stars, and finally of us.” —From Stephen Hawking’s A Brief History of Time

Whether we like it or not, certain cosmological truths require us to be tactical asset allocators.   That is the revelation that came to me while reading a description of the workings of the universe by Stephen Hawking, the renowned cosmologist.  It contains intriguing parallels applicable to understanding how the economy, markets and investment management work.

More down to earth, economic expansion occurs thanks to tactical asset allocation across asset classes, sectors and securities.  This expansion is uneven – lumpy in the analogy of Hawking’s cosmology – rather than uniform across the economy.

Tactical asset allocators act as economic agents in reallocating financial resources to the most efficient use.  Corporations act in the same manner in reallocating their own capital resources.  These two groups of agents influence each other in allocation decisions and, importantly, changing resources in both size and composition.

In a world of uniform expansion, long-term strategic asset allocation would be identical to short-term tactical asset allocations, and both would equal the market portfolio.  Equilibrium would rule the day in the economy and capital markets.  But neither the economy nor the universe is thus.  Uncertainty in the marketplace prevents this equilibrium from taking place.  Players within each of the numerous subsystems making up the economy react to perceived changes in the economic universe by altering their position to conform to their expectations.

Players have strategic plans based on long-term expectations and goals.  The more change occurring in a subsystem – by tactical design or random processes – the more change will occur in other subsystems in the universe.  A whole related discipline, game theory, has been developed to analyze the economic decision-making process underlying these movements.  During periods of major tactical shifts in the financial markets, I have to believe similar tactical shifts occur by players in the real economic markets.

“The more accurately you try to measure the position of the particle, the less accurately you can measure its speed, and vice versa.” —From Stephen Hawking’s A Brief History of Time

Thus, the more an investor views long-term expectations as being dynamic and unstable in nature, the larger are the asset allocation discrepancies between the long-term strategic mix and short-term tactical moves.   It makes no sense for investors to have a static, long-term mix while at the same time taking dramatic short-term tactical bets.  

In other words, this is the uncertainty principle.  Investors spend time measuring the position of economic subsystems and forecasting capital market movements.  The closer scrutiny research analysts employ on assessing the strategic position of a company, the more likely is that company to react to that scrutiny over time and move farther away from that position in meantime.  The more time investors spend scrutinizing an anomaly in the pricing of securities, the faster that anomaly will likely be arbitraged away.

In the real or financial economy, the two groups of players are buyers and sellers.  In a sense each buyer and seller, together with their desire to transact can be thought of as a fusion of separate subsystems to create a single larger subsystem.  Each time a new buyer or seller enters this subsystem, an increased amount of activity occurs.

Price movements in the market occur as players try to find equilibrium.  Only transitory equilibrium can ever exist, however, because new buyers and sellers with different perceptions and objectives continually enter the system.  That is what makes the marketplace.

A dramatic example of this law would occur with a breakdown of cross-border trade constraints.  The price of, say, rice might be in equilibrium in the separate markets of the United States and Japan.  However, the Reader could easily guess what would happen to the level of entropy if there were an instantaneous end of rice import controls in Japan.

Asset allocators – whether tactical or strategic – attempt to comprehend the entropy of the economy by mentally organizing into manageable subsystems.

“When two systems are joined together, the entropy of the combined system is greater than the sum of the entropies of the individual systems.” —From Stephen Hawking’s A Brief History of Time

Although regulatory factors might define certain subsystems, where we draw the boundaries is less clear than what we presume.  Many academics, for example, view companies not as single entities but as a host of complementary and competing subsystems.  IBM Corp. is using this view as it reorganizes into distinctive business units that must compete with outside vendors as internal suppliers.

Moving a step out, we believe the security transactions within the stock subsystem behave more similarly with one another than with, say, real estate, which belongs to another subsystem.  But should the pattern of returns to, for instance, J.C. Penney Co. stock move more similarly to IBM stock, rather than to a real estate closed-end fund dominated by retail properties?  Paradigms sometimes hold us prisoner in understanding what we are doing.

If these principles didn’t hold, pension funds and everyone else would invest in the market portfolio and that portfolio would remain stagnant.  The divergence from the market portfolio and from one another’s portfolio only partially reflects each investor’s cash flow requirements and risk tolerances.  Most of the divergence in our strategic policies are due to implicit or explicit tactical bets.  So we are really all tactical allocators.   Like it or lump it.