The Simon Hypothesis and Investing

I try to attend the weekly NYU Colloquium on Market Processes when the market is relatively boring (it was after the business with PBR). This week I learned of something called the Simon Hypothesis (named after the Nobel Prize winning economist). It is stated thus, "Human beings, viewed as behaving systems, are quite simple. The apparent complexity of our behavior over time is largely a reflection of the environment we find ourselves in." He comes to the hypothesis by describing an ant needs to arrive to a destination. Does the ant go straight to the destination? No, it lives in a complex environment of ups, downs, and possibly dangerous run-ins with birds. The ants system could be as simple as see block, go left (or see bird, hide). The ant's path is complex not because the ant is complex, but because the environment the ant finds itself is complex. The hypothesis is asking if there is any way to predict which way the ant will take on a second journey?

That is an empirical question, but I think most people's first hunches would be that it would be impossible to predict. I would argue that this much is true for many walks of life, particularly investing. We might know the ant's final destination ahead of time (or the subprime crisis, or the internet bubble to burst), but how we get to that conclusion would be different every time. So while a backtested strategy might look sound on paper, ultimately, there is no way to tell if the path which reached a destination in the past will reach the destination in the future. The most important aspect of long-term investing is thinking about why the fundamental economic reasons why the strategy should earn abnormal returns in the future (if you can't think of any good ones, put your money in index funds and T-Bills). In the TAA case, I believe it takes advantage of the boom/busts inherent in markets (with central banks). A deep value investor or distressed debt investor survives through their entrepreneurial foresight (much more important to the Austrians than the neoclassicals which could be one reason why they don't teach value investing with a tenth the attention payed to CAPM), and so forth.

I guess the key insight is that you need to be flexible. You're not sure where the path can take you, so you should always try to find the shortest route when you can. You're never sure what surprises can force you to take twice as long a route, but in markets like this, it isn't hard (WB, BSC,ABK, WM,etc).