Sunday, October 26, 2008

Economic Recessions, Mass Extinctions, & Buying American

Contrary to some opinions, an economic recession is not like a Christmas sale at Macy’s. Yes, they both lower prices and provoke all sorts of mad rushes. But recessions are grave. They’re long hard winters in the wilderness. Companies die. They resemble mass extinctions over evolutionary history, and in that sense have a fascinating, maybe even positive long-term effect. Yet recommendations to buy buy buy, even from Warren Buffett, need to be taken with a grain of salt.

Survivorship bias gives us an overly rosy depiction of history. The term draws attention to an inherent bias in types of retrospective analysis; it's due to how many historical studies only focus on entities that still exist today. For example, most studies of stock market activity during the great depression will only look at companies that survived the whole great depression. This is because companies that go out of business don't have an effect that is easily quantifiable. Empirically speaking, this bias causes analyses to overestimate historical achievements by overlooking public companies that went under.

Survivorship bias is often explicitly recognized as a factor, but it's usually minimized as a statistical artifact, or a minor inconvenience that pops out of data - something to keep in the back of your mind while you’re looking at market trends. But it fully permeates how we judge the stock market, and you can see this on an intuitive level as well:

Think to yourself, quickly, of a few companies that you should have invested in 40 years ago.

Simple enough. Now quickly name a few companies that you shouldn’t have invested in. It’s a bit harder - especially if you don't follow the market closely. But there are tens of thousands of lousy investments over stock market history, and many of them quietly went out of business.

Economic recessions further inflate survivorship bias as the frequency of bankruptcy increases. That is, more businesses go bankrupt, so more businesses are taken out of a study's view. Following an economic recession - and they can last anywhere from years to decades - the market often recovers, and you hear about how great it would have been to buy in while stocks prices were so low. This is often true, and in retrospect you can cherrypick some stocks that would have made you a ton a money. What you don't see are stocks of companies that simply went out of business, which would've lost you money. And this is particularly relevant for buy-and-hold value investors, with time increasing the chances of going belly-up.

With time recessions yield rich fruits. No doubt they’ll provide a few great value investments, but in the grander sense, things always get better. Just as personal challenges offer the best opportunity for growth, recessions stimulate growth. They provide space for new entities to operate.

Biological evolution provides an eerily similar scenario: Scarcity, tough times – long hard winters – stimulate living creatures to evolve. Mass extinctions have a much stronger effect on evolution than times of plenty. Species that survive extinctions are more likely to live through future disasters. While species that die off leave niches for better ones to take their place.

It’s no mistake that humans originated in Africa, which contains some of the harshest climates in the world (along with the most diverse climates in the world packed into one continent). Our relatively modest physical stature may have allowed us to develop alternative resources – like intelligence – in order to survive. Unlike gorillas, we couldn’t rely on physical strength alone (while smaller animals like monkeys often rely more on social living).

Natural resources, like a gorilla’s brute strength, often actually negate the short-term need for intelligent solutions. Economically, a plethora of resources often curse a country’s economy (as with Russia and the Middle East). While in contrast wealthy countries contain relatively few natural resources.

Survivorship bias heavily skews our perception of evolutionary history, even moreso than it skews our perception of the stock market. For every species alive today, there were hundreds of thousands – perhaps millions – of extinct species. A common myth of evolutionary history is that we currently live during at its peak. This belief may partially in true in some regards – we maybe the most advanced intelligent species that ever roamed the earth. But such judgments are heavily egocentric in their assumption that intelligence is the end-all and be-all of evolution, which is very improbable, and they also ignore other forms of intelligence exhibited by species as wide-ranging as ants and beavers. It's a clear cut case of survivorship bias, just like in the stock market, because we're not seeing all the creatures that have died in the past.

Still, harsh times are generally followed by better ones – not just because things can only get better, but because we become equipped with better tools to help us overcome future hardship. In the wake of our current recession, some well-established companies will be able to lick their wounds and thrive again, and new and improved companies are going to crop up where poorer ones failed. Certainly this provides a window for some great value-investments. But I would encourage the shrewd investor, in picking his buys, to still see these times for what they are, and to recall that entities as promising and diversified as the mammoth, trilobite, and triceratops have all had their day.

Media (in order of appearance)

Photo: (1) photo of Warren Buffett, "Warren Buffet DRINKS YOUR MILKSHAKE", 04/22/2008, by Jamais Cascio; (2) A Snow Storm in Naeba, 02/26/2008, by FoNgEtZ; (3) fight, 05/07/2006, by scottjlowe; (4) Surfing Rainbow, 01/07/2006, by Mila Zinkova; (4) Photo of a recreation of a Mammoth, 2006.

Video: (1) Aphex Twin - Rhubarb On Classical Guitar, 04/17/2007, from dalycitytwins, rendition based on the song "Rhubarb" by Aphex Twin, 03/08/1994, from Selected Ambient Works Volume II.

Upcoming ideas:
  • More on the evolutionary difference between plenty & scarcity
  • How positive psychology is at odds with evolutionary theory
  • The upside of things is qualitatively different from the downside

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1 comment:

  1. Add my home of Canada to that group of countries that rely on abundant natural resources at the cost of innovation.


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