It is said that people are better able to make a decision when the number of factors and variables are small. Increase the number of variables and the human brain shuts down. If you show an investor 100 mutual funds, they will find it next to impossible to make a decision, as opposed to the much simpler outcome if you narrow it to 2 or 3. In reality, a reference to a 100 fund universe should be an easier decision than a 2 to 3 sample drawn from that universe. But why?
First of all, in terms of markets and economies, we are in brain shut down territory just now:
- China growth slow down, known about for a while.
China excess gross fixed cap investment – known about for a while.
China shadow banking system – known about for a while.
Strains on Chinese shadow banking system recently known but impact unknown.
QE, US, UK, Europe and Japan – impact on asset prices known, risks to asset prices unknown but being felt now.
Slow economic growth in US, stagnation in Europe, last chance saloon in Japan, gathering issues/crisis in the BRICS and other BRIC like countries…
Limits on fiscal support largely reached, limits on QE more or less reached.
Increasing volatility; asset prices highly correlated; considerable uncertainty as to portfolio flows.
But just why do humans get to brain shut down territory? Because as a whole we are not capable of replicating complex systems within our decision making processes – most people think linearly and can only handle a few variables at a time. We not only make linear short cuts in our brains that cut out important relationships, but transfer those processing flaws into the systems we use to manage and understand risk. As such, it is not the number of variables that matter, but the lack of a framework that can relate the variables to the dynamic whole.
Indeed, if we go back to the fund problem, a complex system would tell you where you want to be and how much, and would select the most efficient vehicles that met these parameters. We have the capacity to develop complex systems that better understand and account for the physics and dynamics of relationships, but we choose not to.
In retail financial services we are still operating in limited processing space, that is delivering simple solutions that only appear to work when the trajectory is up. When problems hit, we do not actually know where we are in relation to the whole and the actual physical relationships that drive everything.
By increasing the complexity of the processing we can manage complexity, simplify its understanding and provide more effective solutions. That is instead of simplifying the solution while ignoring the problem/shoving it under the carpet.
Of concern though is the fact that the cerebellum of the global financial and economic system is close to blowing a fuse. The variables are increasing and the simple frameworks we use are drawing a blank!