Complexity, Context, Probability & Bias

No one seems to remember the second part of Occam’s razor as rumored¹ to be stated by Albert Einstein: “Everything should be made as simple as possible, but not simpler.”

That is an issue I am encountering quite frequently these days. We see it in discussions about markets, politics, sports, economics, indeed, just about any field where questions of an unknown future drive debate. This morning, I want to briefly discuss the issue, pointing out a few recent examples. My advice is to be wary whenever you see this approach.

First, let’s understand what Occam’s Razor actually means: When we select among competing explanations for any given unknown, we prefer that which offers the simplest explanation of any effect. This includes that which makes the fewest assumptions, and requires the least logical contortions. However, one should proceed to simpler theories until simplicity can be traded for greater explanatory power. This is especially true when it comes to explaining complex events with lots of moving parts.

Consider the following statements:

Politics: No modern president has ever won a second term when the unemployment figure was 7.3% or more.²

Markets: The average Bull Market lasts 31 months.³

Sports: The new line up of (Choose: NY Knicks Jeremy Lin/Carmelo Anthony or NY Jets Mark Sanchez/Tim Tebow) locker room disruption.

Credit Crisis: High levels of leverage existed prior to the crisis without incident.⁴

Apple (2004-10): Has a very high P/E.

Affordable Housing Policies: Allowed lower income people to purchase homes they could not afford.

Note that I did not include any conclusion based upon these single variable analyses. But these are the simple, recognizable memes circulating the intertubes. They lay traps for the unwary. The conclusions the authors of these draw are:

1. The incumbent will lose in November
2.Sell your stocks
3. The Knicks and Jets cannot win a playoff
4. Leverage was not a factor in the credit crisis
5. Don’t Buy Apple
6. It was all Barney Frank’s fault

These are all probability questions. When doing these analyses, we do not know what the future outcome will be. Certitude in the face of probable outcomes is discouraged, as is gross over-simplification.

I have addressed many of these over the years (I want to get to the leverage issue soon).

Some people work backwards: They start with their conclusion, than set about hunting for any data that supports it. This is the worst form of confirmation bias. The preferred method is to research all of the relevant data, and see what conclusion that leads you to.

Bottom line: When it comes to investing, the errors of single variable analyses, oversimplification and bias all can be very expensive. Recognize these flaws when you encounter them in any sort of commentary, and adjust your expectations accordingly.

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Previously:
Single vs. Multiple Variable Analysis in Market Forecasts (May 4th, 2005)

Hume, Causation & Science (January 14th, 2012)

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1. Provenance: There is some question as to the whether Einstein actually said this, according to (Quote Investigator)

2. Unemployment rate by year (BLS)

3. This Bull Market Is Hard to Pin Down (NYT)

4. Bethany McLean: The meltdown explanation that melts away (Reuters)