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Towers Watson: complexity coming straight at you

Economics and markets are complex and adaptive; the future is not predictive...” Tim Hodgson

To be a long-term investor requires thematic investing because markets and economies are complex adaptive systems, according to Tim Hodgson, global head of the thinking-ahead group at Towers Watson.

Hodgson told delegates at the Towers Watson Ideas Exchange in Sydney that economies and markets are complex and adaptive, their path is not random and the future is not predictive.

“We don’t live in a linear world. We must hold truths in our head while we navigate the future. A single market price cannot reflect this,” he says.

Towers Watson believes that there are a number of interconnected issues that will converge in the next decades, and which it outlines in its 2013 secular outlook on thematic investing, which will require transformational change.

“It is coming straight at you: the asset owner and you have to deal with it whether you like it or not,” he says.

Recognition of the interconnectedness of these issues is essential.

Hodgson says traditional investment thinking is drawn heavily from economics, which has separate disciplines. The micro side of economics is well developed and the industry is disciplined in how to optimise a portfolio, value a company or price a derivative, all in isolation. But the macro side, including the emergence of bubbles, is almost completely unknown.

Complex system, complex thinking

Hodgson advocates for complexity thinking when it comes to finance, which comes from the study of complex adaptive systems.

Those systems have these common elements:

  • They have simple individual components, but rich complex behaviours.
  • They are adaptive, not in equilibrium and the system behaviour changes in response to external environment.
  • There is signalling and information processing between the components.
  • There is no central control, rather systems are not controlled by any coordinating body, but there is complex collective behaviour.

“Complex systems are where the whole is greater than the sum of the parts. You can’t break it down to understand it and put it back together again,” he says. “Markets and economies are complex systems.”

By way of example, he says academic textbooks in finance teach that everyone is making individual decisions in isolation, but that is not true.

“Markets are coupled and interacting; my trades change your prices,” he says.

He also says markets have multiple scales in time and space, and that fat tails are created by market participants.

In this regard, markets do not have a normal distribution, rather a “power law” distribution where the tail is much fatter.

“We shouldn’t be surprised by the large price moves. If you are, you’re using the wrong distribution.”

He also says that market returns are not random and “rejects” the random-walk philosophy.

“Economics and markets are complex and adaptive; the future is not predictive. As a long-term investor, you have to anticipate this otherwise you are at the whim of market prices.”

“Equilibrium is dead. It is the interconnectedness of finance that categorically matters. Tail events are normal,” Hodgson says.

Not alone

Further, his argument is that finance is not the only industry that is complex.

Health, crime, pollution, climate, economies, urbanisation are all complex and all coupled.

In its 2013 secular outlook on thematic investing, the Towers Watson investment committee outlines six key elements: economic imbalance, adverse demography, degradation and natural capital, innovation and technology, business nexus and government.

While acknowledging the thinking is the easy part and a lot of implementation of these ideas is still to come, he believes it will see a shift from dull market-cap portfolios to bright thematic portfolios.

Hodgson says this cannot be achieved by putting in place one or two themes and hoping it all works out. Rather, the themes need to encompass a complex and wide range of outcomes, with an option-like payoff.

 

 

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