My boss uses an analogy about a beaten up stock or bond. He says that this security is like a boat that is filled with rocks and lies at the bottom of a lake in equilibrium. As investors get less negative about the security, it equates to taking rocks out of the boat one at a time. As more rocks are taken out, the boat moves away from the bottom. Finally, when one last ‘critical’ rock is thrown out, the boat rushes to the surface into a new equilibrium.
This scenario of taking out one critical rock that causes the entire boat to rush to the surface lies behind “Chaos Theory” – small changes that cause diverging outcomes in dynamic systems. This is the backdrop of John Gribbin’s book, “Deep Simplicity: Chaos, Complexity and the Emergence of Life”.
Gribbin breaks “Chaos Theory” into a simple idea – the sensitivity of a system to its starting conditions and the feedback loop. Things such as the spots on a leopard or the shape of a snowflake follow simple laws. He talks extensively about fractal geometry that lies behind patterns that repeat itself like the ragged coastline of Britain or Norway. In the financial world, we see the equilibrium of stock markets broken by a critical event every now and then. When this critical stage is reached is not known.
During the credit crisis of 2008, Keith Sherin, the Chief Financial Officer of General Electric, mentioned that the global economic problem was in a one-in-80-year event. Similarly, “Deep Simplicity” makes a case that other activities in nature like the occurrence of an earthquake follow a “power law”, meaning that an earthquake of intensity eight occurs fewer times than one of intensity four. Riveting!