Investing and the butterfly effect

In our world of complex systems, there exist cases where small changes can have profound effects on system outcomes. This concept is popularly known as the butterfly effect or the chaos theory. It was popularized by Edward Lorenz. The butterfly effect is the idea that small things can have nonlinear impacts on a complex system. The concept is imagined with a butterfly flapping its wings in the Amazon and causing an earthquake in Japan.

Of course, a single act of the butterfly flapping its wings cannot directly cause an earthquake. Small events can, however, serve as catalysts for the same.

So why are we talking about the Butterfly effect in Investing?

Our field of investing and finance could probably top the list of complex systems and would make an ideal case of how small changes could have extreme outcomes.

Markets are complex systems because its movement depends on the behaviour of millions of market participants at any given point in time. Yet, the world over, fund managers try to predict what will happen tomorrow. Switch on any news channel and you will have market pundits trying to predict how steep tomorrows rise or fall would be. How could they possibly know? They don’t. They just play on our financial illiteracy. Not only Channel anchors, but fund managers also try to time the markets.

A commonly cited rule of thumb suggests 90% of the market’s absolute return is typically accounted for by the moves of only 10% of the trading days. To illustrate the importance of this concept, the figure below compares the compound annual price return of the Nifty50 over the 20 years ended December 2017 to the theoretical results if participation in the market was excluded for just the 10, 20, 30, and 40 best days of this 5000+ trading day period.

An investor who hypothetically remained invested in the Nifty50 throughout this period would have earned a total annualized return of 11.96%. A notional investment of $100,000 at the beginning of this period would have grown to roughly $1Million. By excluding just the 20 best-performing days in that time period, the compound annualized return drops to 4.51% and By excluding the 40 best-performing days (still less than 1% of the trading days in the period) the total return becomes negative, eroding the initial investment to barely $70,000.

Did you see the butterfly effect come in to play here? A small change in the system and the outcome changes completely. It shows how complex our markets are. The backtest shows us that 90% of the markets returns tend to come in just 10% of the days. Yet money managers deploy complex models to successfully time the market.

85% of fund managers in the US have underperformed the S&P 500 Index. In order to achieve an extra 2%, a lot of funds end up losing the 12% they could easily make. To explain this concept, Benjamin Franklin offered a beautiful poetic perspective:

For want of a nail, the shoe was lost,
For want of a shoe, the horse was lost,
For want of a horse, the rider was lost,
For want of a rider, the battle was lost,
For want of a battle, the kingdom was lost,
And all for the want of a horseshoe nail.

The lack of one horseshoe nail could be inconsequential, or it could indirectly cause the loss of a war. Similarly, in trying to time the market you could miss out on big moves that could change the trajectory of your returns. Positive systems could easily turn out to become a disaster.

Warren Buffet and Charlie Munger understood this concept way before most of us were born. They often said:

“ It’s the Time in the market, not timing the market that matters”.