Why investment bubbles are necessary

Here and now, in the first decade of the 21st century, we are truly living in tumultuous times. All you have to do is glance at a newspaper to see this is true.

As Chairman Mao once said, "There is great disorder under heaven. The situation is excellent." I believe that in the past 50 years, and perhaps the past century, there has hardly been a better chance to amass a great fortune. Or to lose one.

As the world grows more complex, understanding becomes ever more precious. Stock picks are good - but they are not enough. With the stakes so high, I believe we need more than just investment ideas. We need clarity - a deeper level of understanding as to what is happening, and why.

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Why we need mental models

As it turns out, an excellent clarity-development tool is the mental model.

Why do mental models work so well? Because we, as human beings, like to think in terms of analogies. It's natural to relate an unfamiliar thing to a familiar thingto connect a foreign concept with a concept we can understand. Mental models help us do this.

Charlie Munger, the lesser-known partner of Warren Buffett, captures the power of mental models with something he calls "latticework."

Munger puts it like this:

"The first rule is that you can't really know anything if you just remember isolated facts and try and bang 'em back. If the facts don't hang together on a latticework of theory, you don't have them in a usable form."

So with latticework, we take the humble mental model a step further. To develop "elementary worldly wisdom," as Munger calls it, we cannot rely on a hodgepodge of jumbled ideas and randomly collected notions. We have to make sure it all "hangs together" in a way that makes sense. Our mental models have to be incorporated into logical, accessible theories that shed light on how the world works.

And of course, the more horsepower our theories have, the better. Consider these words of wisdom from Adam Smith (not the 20th century pseudonym, by the way, but the original Adam Smith, author of The Wealth of Nations ):

"The theory that can absorb the greatest number of facts, and persist in doing so, generation after generation, through all changes of opinion and detail, is the one that must rule all observation."

Now, Adam Smith shuffled off this mortal coil nearly two decades before Charles Darwin was born. By the time The Origin of Species was published, in 1859, Smith was nearly 70 years in his grave.

Yet if any theory "rules all observation" as Adam Smith suggested, if any theory measures up to the power of that quote, it is the theory of evolution.

Markets are evolutionary

In terms of raw explanatory power, the theory of evolution - with its emphasis on competition, diversity, and natural selection - gives more bang for the buck than any other.

Many, in fact, view markets through the lens of evolution. Competition, natural selection, and rapid speciation are certainly in evidence. One could even say Wall Street is "red in tooth and claw."

And as Eric Beinhocker recently reminded us, the markets are not just like an evolutionary systemthe markets are an evolutionary system. There is a rich financial ecology, an incredible variety of eco-niches, and a mind-boggling array of market variables. There is sensitive dependence on initial conditions. There are Cambrian explosions and mass extinction events. And of course, there are market participants of all sizes, from the mighty whale to the lowly dust mite.

From a historical perspective, we can look back and see the evolutionary path of markets unfold. We can dig through the annals of finance in the same way a paleontologist digs through rock and sediment, searching for remnants of the Devonian, Carboniferous, and Permian periods.

We can discover fossilized financial artifacts, not unlike the ancient trilobites that roamed the sea floor a quarter of a billion years ago. For example: Babylonian loan contracts have been traced back to the 24th century B.C. The earliest known incorporation documents were drawn up by Roman government contractors in the fourth century B.C. Fiat currency circulated the lands not long after the New Testamentand so on.

Step by step, we can trace the path of financial innovation - from its rudimentary beginnings on through to the stunning levels of complexity seen today.

But just as there are powerful disagreements among economic schools of thought, disagreements exist in Darwin's world too. Soon after the theory of evolution took hold in the scientific community, a significant rift appeared.

Darwin was a firm believer in the doctrine of "natura non facit saltum," which translates from the Latin as "nature makes no leap." The process of evolution, according to Darwin, is wholly a gradual, progressive one. Evolution is the cumulative result of small, incremental changes over time.

The problem with this notion is that the fossil record never truly supported it. Evidence of gradual, continuous change turns out to be in painfully short supply. The gradualists worked around this by chalking it up to "gaps in the tape"as if the fossil record were a book with chapters torn out, forever lost to the sands of time.

The core assertion of "natura non facit saltum" also bears uncanny resemblance to that of "continuous-time finance," a market theory proposed by Nobel Laureate Robert C. Merton. According to the continuous-time finance model, markets make no leap either. All changes are smooth, gradual, and orderly, like calm waves in an unrippled sea.

Unfortunately for Merton, he witnessed a violent refutation of his theory firsthand, as an ill-fated partner in Long Term Capital Management. One could say the notion that "markets make no leap" came to a rather punctuated end.

What is punctuated equilibrium

Which brings us round to punctuated equilibrium. After a hundred years or so of post-Origin bickering, a powerful new challenge was presented in the early 1970s by paleontologists Niles Eldredge and Stephen Jay Gould.

Unlike previous theories, Eldredge and Gould's efforts were backed up with a body of painstakingly accumulated evidence. Their "theory of punctuated equilibria" -- more commonly known as punctuated equilibrium -- asserted that evolutionary change is not actually gradual or continuous. Rather, it is compressed into relatively tight bursts of geologic time.

(In a sign that the scientific community has a sense of humor, the ongoing debate was then cast as "evolution by creeps" versus "evolution by jerks." Not much of an aesthetic choice there.)

But while people tend to associate punctuated equilibrium with the idea of rapid or accelerated change, that isn't the most interesting thing the theory has to say. The deeper assertions of P.E. are more far-reaching and profound. Here are three examples.

One: The status quo is far stronger than we think. The idea that things are always improving, that the forces of change never rest, is simply not true.

Two: Evolution does not occur in uniform fashion, and change tends not to apply to the species as a whole. Instead, change occurs in small pockets at the periphery. (At "the edge of the network," as Andy Kessler might say.)

Three: Over time, those small pockets of change at the periphery create critical advantagesand eventually, the advantaged periphery invades the stagnant center. Thus, in a very real sense, the status quo does not actually evolve. It goes extinct! As the edge of the network expands, a new center is createdcrowding out the previous one.

Why 'punctuated bubbleibrium', then?

The reality of punctuated equilibrium thus bears greater resemblance to market forces than we realize. We can see that the status quo tends not to changejust as large, lumbering companies are loath to change. We see that real evolution happens in small, out-of-the-way placesthe two guys in a garage, hanging out at the edge of the network. And we see that the old centers tend to be crowded outjust look at the moribund newspaper industry, fighting Google on the one hand and Craigslist on the other.

As a mental model, punctuated equilibrium dovetails exquisitely with Joseph Schumpeter's ideas on "creative destruction" and Clayton Christensen's ideas regarding the "innovator's dilemma."

But lest we forget, the title of this talk is "punctuated BUBBLEibrium."

So why the bubble twist?

Because, far from being something that can be managed or stamped out, the existence of bubbles may well be intrinsic to man's evolution as a species. Overenthusiasm and crisis management are simply the mechanisms by which we learn.

The poet William Blake perhaps put it best when he said, "The path of excess leads to the tower of wisdom."

The path of excess leads to the tower of wisdom. True words, indeed. Sometimes, the only way to find the line is first to cross itand then look back in hindsight. To answer the question how far is too far, one must sometimes push too far to find out. As Jesse Livermore, the greatest speculator of all time, once mused:

"Fate does not always let you fix the tuition fee. She delivers the educational wallop and presents her own bill, knowing you have to pay it, no matter what amount it may be."

With the words of Blake and Livermore in mind, let's consider three market realities that qualify punctuated bubbleibrium as a mental model.

First: the reality of the crowd mechanism. In his book More Than You Know , Michael Mauboussin talks about how markets facilitate price discovery through the wisdom of the crowd. As it turns out, the "best guess" of a crowd can be highly accurate in terms of valuation, as long as opinions remain diverse. When there is a broad spectrum of views, the crowd does its job.

When a majority of the crowd forms a like opinion, however, the price discovery mechanism gets distorted. It becomes easy for things to get out of whack -- like a ship with all the weight on one side. When "everyone" is convinced of something, conditions are ripe for a bubble to arise.

But consider too that sometimes a bubble is exactly what's necessary to disrupt the status quo. Take hard assets, for example: Are institutional buyers and investors creating artificial "bubble-like" demand for hard assets by irrationally hoarding them? Or is the desire to stockpile hard assets a wholly rational response to the dollar's inevitable fate and the projected growth curve of the developing world? The question quickly becomes chicken and egg, as bubble questions tend to do. Fortunately, the market is not required to explain itself.

Which leads to our second market reality: the fact that markets discount the future, not the past. It's not uncommon to hear an analyst to say, "Based on such and such historical data, we feel that such and such price is (or is not) justified." Sometimes this viewpoint has merit. But more often than not, it overlooks the fact that tomorrow is setting up to look quite different from today. The markets are concerned with what is going to happen next, not with what's already in the books. Reversion to the mean works well as a rule of thumbexcept when it doesn't.

Finally, there is the reality of tectonic pressures. Conditions can appear stable for long periods of time, even as hidden pressures build up beneath the surface. The heavy plates of the earth's crust can press against each other, building pressure with cumulative forceand offering no warning until the day something slips. At that point, the pressure is violently released, seemingly out of nowhere -- but actually a result of long buildup over the years.

I would now love to share some specific, detailed examples of punctuated bubbleibrium at workbut the good New Orleans folks only gave me 20 minutes. Not that I'm complaining! I was happy to get even that, with such an amazing list of speakers on the roster.

With topics such as these, one can only hope to scratch the surface on the first go. But that's what makes the exercise so worthwhile, in my opinion.

A side note to readers: I shall delve deeper into punctuated bubbleibrium and other "latticework"-type concepts in future Whiskey essays. (If you find such intellectual speculation worthwhile, that is.)

By Justice Litle for Whiskey and Gunpowder

Whiskey & Gunpowder is a free, twice-per-week, e-mail service for more from the team, go to https://www.whiskeyandgunpowder.com