Systems and Decisions

Originally written — 10/28/15

In Short

The systems and patterns by which we make sense of our world are changing. Examining these systems tells us a great deal about what patterns to expect in the near future, and the implications for our markets and societies.

Man’s Reach vs. Man’s Grasp

There is a natural tension between our ability to collect information and our ability to understand the information we collect — naturally, the latter consistently lags the former. After all, we cannot understand things we don’t yet know. However, there are ebbs and flows during which our ability to collect information far surpasses our ability to understand it. Recently, we have seen this gap widen. As evidenced by the rising popularity of “technology detoxes”, our ability to access vast amounts of information at any time, without understanding it, has come with a cost. Behavioral psychologists have occasionally termed this sense of being overwhelmed as the paradox of choice — that more options or inputs may actually make us less happy and lead to worse decisions.

In some respects, our struggle to process and subsequently understand information has come as the systems of acquiring information and understanding it have become increasingly independent. Whereas we once acquired a great deal of carefully curated and presented knowledge in school, the rise of print and then television media led to a broadening and increase in the information presented to us, with a rapidly decreasing amount of filter or context. The advent of the 24-hour news cycle exacerbated this phenomenon, particularly as news programs became less instructive and more entertainment. In the modern era, with the shift to Twitter and Facebook newsfeed, the latest events are immediately presented at a dizzying pace, with no framing or broader perspective. This has furthered the gap between the amount of information we receive, and our ability to make sense of it and understand its relation to our daily lives.

In a world where we are presented with an increasing amount of information, how do we make sense of it all?

Executives versus Managers

We tend to employ two primary modes of processing and understanding information — systematic and idiosyncratic. The difference between these approaches is perhaps best articulated as the difference in perspectives between an executive and a manager.

The executive is concerned with longer-term trends in the business. They are responsible for answering to a wide number of constituencies, from shareholders to department heads. As such, their perspective is shaped, and somewhat captive, to the demands and priorities of these various constituencies. Thus, taking a systematic approach, which identifies the best response on average is the most effective way for them to process information.

On the other hand, the manager is in the weeds. The manager is concerned only with the demands of their team, and the immediate-term issues they face in their work stream. As a result, their focus is necessarily on the more idiosyncratic events that have the potential to disrupt their day-to-day life, rather than the macro concerns of the firm or other departments. Their priorities necessitate taking a select few data points at a time to guide their response to the nearest crisis.

These models do not just exist in abstraction — we are seeing them play out in multiple spheres, perhaps most consequentially in US politics and financial markets. In politics, Hilary Clinton has been marked by a notable “executive” approach to her campaign. As she attempts to appeal to various constituencies, Clinton has often resembled an econometrics models trying to hit a requisite number of variables. Unsurprisingly, this has led to relatively few questions about her competency, but a great many about her reliability and ability to connect on an individual level. Conversely, Bernie Sanders has stuck out by running a decidedly “manager”-style campaign (somewhat paradoxically given his professed desire to be a uniting force across constituencies). By pegging himself firmly on the single issue of economic inequality and injustice, Sanders has eschewed a broader, systematic view and instead seeks to drive every conversation back to a single issue.

Similarly in financial markets, the rapid growth of ETFs speak to a growing “executive” mindset amongst investors. Rather than attempting to take highly differentiated positions, investors are opting simply to take broad market or factor-based exposure, sometimes managed through quantitative rebalancing as robo-advisors have grown in prominence. On the other hand, the tendency of many investors to ignore broader patterns, trends and information in favor of recent or particularly shocking individual data continues to be reflected in periods of sharp market turns and volatility. Most notably, during the US market plunge in Q3 2015, investors overreacted negatively to Chinese currency devaluation, despite significant prior evidence of economic weakness in China.

So, given the existence of executive and manager approaches to process information, who is winning? Why does it matter?

Winners; Near and Far

How we process and understand information matters because it dictates the timelines by which decisions are made. Do we expect markets to be volatile going forward? Is every budget deal a potential government shutdown? Having a sense of the perspectives of decision makers help us, in turn, to make decisions.

In the near term, while the ratio between amount of information and capacity to process it remains high, we should expect to see a dominance of the manager mindset. As a result, decisions will be made with less complete information and perspectives, creating near-term volatility. However, because this decision making is occurring in a system, we can also plan to counter it. As such, in the near term, winners will systematically approach idiosyncratic behavior. This requires the rigorous evaluation of controversial or unexpected decisions, and the methodical integration of them into one’s strategy. For Hilary Clinton, this meant taking an impromptu meeting face-to-face with Black Lives Matter leaders, heading off an uncomfortable showdown in public, and gaining points in the progressive community for a frank conversation in which Clinton arguably seemed more comfortable and presidential than in any other point during her campaign. In financial markets, it meant maintaining conviction and buying under pressure — which has resulted in a nearly 11% rally in emerging markets equities since the August slide.

However, in the longer-term, as information processing catches up to the available information, our modes of decision-making will shift to primarily an executive mindset as algorithms and models gain predictive power due to greater data availability and accuracy. As this switch occurs, so too will the types of winners in the new information paradigm. In the longer-term, winners will be idiosyncratic. Particularly in financial markets, where the move towards passive management and likelihood of many large players in the same small pond has raised fears of “quant-agion” down the road, differentiated managers will be able to stand out not only in returns, but also in appealing to clients. In this respect, politics has played a leading indicator to markets, as the rise of the Tea Party in 2010 began to foreshadow an increasingly atomized electorate, and the ability of politicians to succeed by appealing to highly polarized, narrow slices of the population.

In Concluding

Predicting the future is always a risky, and usually fruitless, proposition. Instead, it is more valuable to understand the conditions in which the future decisions might take place. By having a sense of these conditions, and the perspectives governing the decisions of individuals, we can understand the range of outcomes. Thus, as information continues to exceed our ability to process it, look for entities that take a systematic bent to their strategy. As these play out, and as information processing improves, pivot towards those with greater idiosyncrasy and ability to stand out from the growing crowd.