Systemic Bedlam

The three-body problem has been giving physicists and mathematicians alike fits since it was introduced by Isaac Newton in 1687 in Mathematical Principles of Natural Philosophy.

The question is how three celestial “bodies” (in Newton’s version, it was the Earth, the Moon, and the Sun) will interact with each other in space accoring to the laws of physics. A general solution would allow its discoverer to describe the system’s behavior and predict its future states.

If only the universe were so simple. Despite centuries of perspiring mathematicians, it seems that for most initial conditions, the system is chaotic. That means something disconcerting: there are more possible ways in which the three bodies might arrange themselves than there are finite mathematical operations.

With condolences to Isaac, it seems no amount of time under an apple tree could have made a difference.

The State of the Market

A quick survey of the state of global markets leaves one with a similar sense of disorder.

Global economies bounced from the rock of a pandemic and caromed promptly into a hard place of unrelenting inflation and geopolitical uncertainty.

In China, the CCP’s radical zero covid policy has weakened a powerhouse economy that was already bracing for an epic housing crisis. Meanwhile, the largest war since WW2 flames along in Europe as an energy crisis severe enough to threaten deindustrialization swells in the distance. On the other side of the Atlantic, political instability and a Volcker-inspired federal reserve seem sure to damage a surprisingly healthy US economy. Everywhere at once, prices boil and interest rates rise.

One could not blame an investor looking for a general solution to chaos for feeling overwhelmed. However, like Isaac sitting fruitlessly under a tree waiting to solve the unsolvable, an investor trying to “figure things out” in a general way is wasting his time.

Some strategic considerations should break the spell.

Alpha Mandates

Many investors have — perhaps ill-advisedly — pursued a path of diversification. If your investment strategy is to simply hold the market, then good news: there’s nothing to for you to do. To do other than hodle is incoherent when the essence of your risk management strategy is to accept systematic risk.

For alpha seekers, the story is different. Holding the reigns to your portfolio does mean that you need to respond to potholes in the road. Importantly, however, it does not mean that you should set out to predict them.

The good news is that for the investor and business owner, there are a few, simple mandates for dealing with uncertainty:

1. Know the road
2. Move like Robby
3. Create dynamic operations

I will examine these three mandates through the the lens of a real estate investment company, though the same logic can be readily applied to other businesses and asset classes.

Know the Road

The essence of investment management is the management of risks, not the management of returns.

Benjamin Graham

To start a venture is to set out on a road untraveled. This is not to say that every venture is unprecedented, but rather that its precedent is categorical.

Imagine the most banal of roadways— say, the one from your house to the local supermarket. That route may always start and end at the same place, but along the way different combinations of red, yellow, and green stoplights and of cars belonging to other travelers will be encountered. Less frequently, accidents, fallen trees, etc will force a new direction or saddle you with an unwelcome delay. Which precise version of the road you will encounter is unpredictable.

That is, of course, no reason to forgo groceries.

While you cannot know the road you’ll travel, you can very well know what a road is generally like. The local road’s unpredictability will not suddenly transform it into a mountain pass, for instance — so you can leave the snow tires at home. You will not know whether drivers behind you are planning to turn or go straight, but you can know that functional blinkers (and habits of using them) hedges against rear-ending. Fallen trees are possible but unlikely, so one need not always budget in the cost of a detour.

Accepting the unpredictability of the road leads to succesfful navigation of it, and thus complexity should guide, not discourage activity.

Similarly, the real estate investor who stands with hands on hips and squints at forecasts would be better off abruptly turning tail and walking over to the local archives. There, some general facts about the industry will emerge.

First, to the extent that real estate can be assessed as a monolith, its historical performance relative to stocks is much more of the smooth, slow, and steady variety. While the greater market bucks and kicks, the real estate market lags and sticks. An investor in 1999 using the dot-com bubble as a signal would read only noise.

Second, market variability is substantial. One need look no further than Zillow’s month over month price index to assess the geographical variance. The range is not only large — it’s a decoupling.

Third — and importantly — there is only one existential risk in residential real estate: mortgage risk. An investor who owns a portfolio free and clear has nothing to fear in a market squeeze; barring a meteor (or maybe, atomic) strike, all he need do is patiently wait for recovery while collecting a modest ROI.

Investors who play a bigger game can not afford such equanimity, and this lays bare the nature of their risk. Those who build with leveraged assets should begin with the knowledge of unpredictable markets in mind and devise a strategy for how they can continue to make their mortgage payments.

The archives can also provide a conservative indication of margin — what is the most rent or housing prices have decreased in similar markets? Double it for good measure.

What a perusal of the archives tells the real estate investor is thus:

1. Ignore macroeconomics — don’t worry about correlative prediction; worry about internal metrics.
2. Choose your markets carefully — don’t worry not about national indexes; worry about local fundamentals.
3. Understand domain risk — don’t worry about sinking valuations; worry about margin.

The investor should look to the past not to predict, but to design. As the road itself is unknowable, “know the road” translates to “customize your vehicle.”

Move Like Robby

Evolution isn’t always better than design. An omniscient designer could find the best strategy every time. The point is that natural selection, or directed evolution in this case, is a really good search strategy. It doesn’t necessarily find the best solution, but it regularly finds impressively clever ones.

Sean Carrol . The Big Picture

Robby the Robot is a virtual robot given a big task by his programmer Melanie Mitchell, a “Professor of Complexity” at the Sante Fe institute. Robby’s universe is a virtual 2d space divided into squares. Strewn randomly throughout his world are empty cans from a night of virtual robot partying, and Robby’s task is to pick them up.

This seems straight-forward… until you learn of Robby’s limitations.

Robby is:

1. Near-sighted. He can only see one square to his north, south, east, or west (not diagonally, and not more than one square away)
2. Amnesic. He can not remember where he’s been, so his formula for searching cannot use more than one command at a time (you can tell him to go left, but not to go left and then to go right)

This complicates things. Given the number of possible moves Robby can make (seven) along with the list of things he can “know” on any given square (> 200), the number of possible Robby strategies is around 10²⁰⁵ — more than the number of atoms in the observable universe.

So, choosing a strategy is a hard problem.

Robby’s situation is familiar. Stumbling around space surrounded by opportunity, the investor cannot see far in any direction. And as it is for the Robby, there are two strategic options — to create a set of rigid, logical rules on which to operate, or to allow experience to create the rules for him. The latter is called a genetic search algorithm, and it mirrors the way evolution guides organisms through a dazzlingly complex genetic landscape.

In Robby’s case, the limitations were known to the experimenters, and yet the genetic algorithm — that is, the algorithm that blindly crafted strategy through trial and error — outperformed the experimenter’s best designed strategies by a considerable margin.

The success of the organic solution is a lesson for business owners and investors alike. While it may feel better to have a rigid theory with which to attack uncertainty, you don’t know what’s going on even in the calmest of markets. So, instead of seeking to chart a path across the board or painstakingly designing rules for reactivity, one should seek dynamic reactivity in operation.

In plain terms, this means deploying new strategies swiftly and paying close attention to the results. Error-orientated probing allows your environment to adjust your operations organically, which, for a blind Robby, is essentially guaranteed to outperform central planning.

As for which strategy to implement, the best one might even be random. In his bestselling book Antifragile, Nassim Taleb recommends that business owners select a course of action by opening the roman poet Virgil’s Aeneid and devising a strategy from a spontaneous interpretation of a random verse.

Even better could be to go get exposure to other businesses through networking. The beauty of our place in time is that many genetic algorithms have already made great strides of evolution — one need not always be crawling from the primordial soup.

If knowing the road is all about hedging against fatal errors in vehicle design, moving like Robby is about committing minor errors in travel to get better at steering.

Create Dynamic Operations

Everything can be improved.

~Clarence W. Barron

The final mandate is to create dynamic operations. To move like Robby, you need to be able to absorb new information; that is, to convert error to solution.

First: know that internal metrics are essential. Everything your business does should be tracked as if your company were an unsuspecting user scrolling through TikTok, and this data should be fed into dashboards that synthesize in a way that signals operational improvement or decline.

These dashboards are more important for a business than any macro-economic indicators could ever be (seriously — ignore those). You don’t know what will happen next, how your market will react to what happens next, or how changes in your market will affect your operations. Happily, though, you can work out the latter without impossible deduction.

Second: operate with little overhead. This does not necessarily mean low spend. Instead, it means low spend-commitment. Long term commitments to salary, marketing, or professional services hamper your ability to move quickly and should be avoided. The month-to-month commitment of most software along with the remarkable ability to outsource instead of hire in the modern economy should be used to the investor’s advantage.

Finally: document, document, document. Everything you do and everything you learn should be documented in careful detail and stored in a way that is accessible to your team. These SOPs will be the hardcoding of your strategy, and so you are only as dynamic as they are. I love the combination of Notion and Loom to create fluid documentation for my business.

Dynamic operations are the mechanism by which you to crystallize vehicle design and learn to steer on bumpy roads. Without them, theory remains just that.

Stay the Course (And Throw Out Forecasts)

Isaac Newton may not have been able to solve the three body problem by sitting under an apple tree, but thankfully, he got up and did other things.

Staring into the jaws of chaos, there are only two forbidden paths to the investor:

1. do nothing
2. forecast

While both are sins in my book, the latter is the greater evil. To try to make decisions based on forecasts is to spend time trying to solve the unsolvable, which for the investor is a recipe for a healthy serving of bad ideas.

If someone tells you they have a general solution for a chaotic system, politely tell them to go kick rocks (or apples).

Further, while the forecasts are out back burning in the dumpster one should consider that inaction in the face of uncertainty is also no soft landing — a paralyzed investor is almost as sure to be weeded out by his environment.

It should be of interest that there are special case solutions to the three body problem. One of them uses a process called the “drunkard’s walk,” where the probability that a drunkard (here an analogy for one of the three bodies) who has an equal chance of turning in any direction (so walks randomly) will end up at any given future point can be reliably calculated by adding up a successive series of probabilities. In other words, you don’t know where the random object will end up, but you can know where it should end up if you know (that you don’t know) how it is moving.

Just as if he were observing a drunkard, the business owner and investor that knows that he doesn’t know how his portfolio will shift and takes according action can be confident that he is feeling his way to an oasis in the storm.

With careful mandates and a humble incorporation of un-knowledge, sense may yet be made of chaos.