Taylor Pearson wrote an article titled A Big Little Idea Called Ergodicity.
« What is Ergodicity? … In an ergodic scenario, the average outcome of the group is the same as the average outcome of the individual over time. An example of an ergodic systems would be the outcomes of a coin toss (heads/tails). If 100 people flip a coin once or 1 person flips a coin 100 times, you get the same outcome. (Though the consequences of those outcomes (e.g. win/lose money) are typically not ergodic)!
In a non-ergodic system, the individual, over time, does not get the average outcome of the group. This is what we saw in our gambling thought experiment. »
« A way to identify an ergodic situation is to ask do I get the same result if I:
- look at one individual’s trajectory across time2
- look at a bunch of individual’s trajectories at a single point in time
If yes: ergodic. If not: non-ergodic. »
« pretty much every human system is non-ergodic. By treating things that are non-ergodic as if they are ergodic creates a risk of ruin… If you want to not die or go bankrupt, ergodicity is an important idea to understand. This is particularly true in the case of financial education. Most finance material assumes ergodicity (that time and ensemble probabilities are the same) even though it is never the case. »
« let’s assume that Nick and Nancy know for sure that their average annual return will be 8% over this 32 year period. That’s great, they’re guaranteed to have enough money then, right? Turns out, no. It is non-ergodic and so it depends on the sequence of those returns…
If these big positive returns happen early in their retirement (blue line), they are in great shape and will do much better than Nancy’s projections.
However, if they get the returns in the order they actually happened, with a long flat period for the first 15 years, they go broke at age 79 (green line). »
« Sequencing matters. If big positive returns come early, Nick and Nancy are in great shape (blue line). If they come late (green line), they are ruined. »
« Many “irrational” behaviors or “cognitive biases” are actually individuals realizing that a system is non-ergodic and not optimizing for expected value. »
« In Search of Antifragility. The central concept of Nassim Taleb’s Antifragile (Taylor Pearson’s Book Notes – Amazon) is the notion that there are two opposing ways in which something can respond to volatility: fragile things are harmed by volatility, while antifragile things benefit from it. »
« Fragile and antifragile can effectively be used as synonyms for non-ergodic and ergodic. A fragile actor is non-ergodic, a truly antifragile actor is ergodic.
« If you graph a fragile system, there is limited upside and unlimited downside. If the traffic is very light, you might get to your destination five minutes faster. If it is very bad, it may take an hour. There is a negative asymmetry. »
« If you graph an antifragile system, there is limited downside and unlimited upside. Going to cocktail parties is antifragile – you can only lose a bit of time (limited downside) but you could meet someone who will change your life (unlimited upside). »
« If you are fragile or non-ergodic, meaning there is some chance of blowing up, then it is guaranteed you will eventually blow up. »
« Effective diversification can make non-ergodic situations more ergodic. There are two ways of thinking about diversification that I find helpful. 1. The Barbell. 2. The Kelly Criterion. »
« The Barbell. The Barbell is an approach that advocates playing it safe in some areas and taking a lot of small risks in others. That is extreme risk aversion on one side and extreme risk loving on the other, rather than just the “medium” risk attitude that is actually a version of Russian roulette.
One example applied to your career would be to get skilled in an extremely safe and predictable profession, say accounting or dentistry, while moonlighting in something extremely risk, say acting. Acting is extremely non-ergodic while accounting is much more ergodic. The two in combination are more ergodic than either alone.
Antifragility is a function of combining a multitude of entities so that each one of them is non-ergodic but the ensemble is ergodic. So you can make yourself more ergodic and antifragile by dividing yourself into an ensemble of entities able to fail independently without “carrying down” the others.
What matters is not average correlation, but correlation during a crisis or black swan event. Take, for example, the size of safety exits in a theater. What matters is not whether they are large enough to pass through on average, but how easy they are to pass through during a fire.
The key from a financial perspective is to prepare for a situation where the markets drop and your job income gets hit at the same time. In one lifetime, it will likely happen. Volatility tends to cluster.
Or, as Vladimir Lenin put it “There are decades in which nothing happens and weeks in which decades happen.” Saying something is ergodic during the decades in which nothing happens is meaningless. The question is whether it is ergodic in the weeks in which decades happen.
One common piece of personal finance advice is to set up an emergency fund – keeping 3-12 months of your expenses in cash that you only touch in times of emergency. This is effectively a rule of thumb which increases ergodicity.
In a business context, this would look like diversifying different choke points in your business. If you rely on a single factory to do all your manufacturing, can you get another factory to do 20% of the work even if you pay more per unit just so you have a back up?
I often advocate an 70/20/10 marketing approach where you focus 70% of marketing spend on the most predictable, boring channel then get progressively more experimental with the 20% and 10%. If the experimental stuff fails, you’re still in good shape, but you have upside exposure if it works. »
« The Kelly Criterion: Cap Bet Size… The key insight of the Kelly Criterion is that you never bet everything and you increase your risk as you are winning but decrease it when you are losing… In effect, this means that the Kelly criterion makes it impossible to go bankrupt which seems like a good idea… The Kelly criterion is about bringing as much ergodicity as possible into non-ergodic realms. »