The Butterfly Effect

There are many versions of the butterfly effect but the one I like is the theory that a butterfly flapping its wings in Brazil could set off a tornado in Texas. The theory assumes that the flap of the wings could create tiny changes in the atmosphere that may affect the path of a tornado. The name of the effect was coined by Edward Lorenz who, in 1961, was using a computer (an extremely basic model compared with today's PCs) to re-run a weather prediction. As a shortcut, he entered 0.506, instead of the full 0.506127, as one of the initial conditions and the result was a completely different weather scenario. In general, he concluded that a small change in the initial conditions of what is known as a 'chaotic system', like the weather, can result in large differences to a later state. Hence the butterfly effect.

Now I think our lives are full of butterfly effects, which are seldom obvious after the event. Because they are not obvious, we rarely recognise them but instead try to rationalise situations using conventional logic. We then kid ourselves that we have 'learnt' from our experiences and apply the same false logic to guide us in the future - a recipe for disaster! For this reason, I hate the expression 'wise with the benefit of hindsight'. The assumption being that you know how you got to where you are now because you have the 'benefit of hindsight'. Well I would argue against that premise. Sure, there are major decisions that you took in your life that if you had made different choices, would have led to a different result but what about the butterflies? Those little things that you never spotted that months or even years later took you down a completely different path to your original intentions.

We are still feeling the pain of the 2007-2008 financial crisis, which politicians are conveniently using as a scapegoat for many of their subsequent bad decisions. It was considered to be the worst financial crisis since the depression of the 1930s and resulted in the collapse of large financial institutions, bailout of banks, downturn in the stock and housing markets, evictions and widespread unemployment. Many economists are blaming the 'burst' of the previous housing bubble in the USA for the problem but is it that simple? I suggest not. Do I have a better theory? Definitely not! What I do believe is that in the same way as chaos theory can be applied to weather prediction, it is equally applicable to financial markets. The similarity being that a tiny change in initial conditions can lead to a large change in results, which is the definition of a chaotic system. Financial bubbles grow because of positive feedback. So, property prices are rising, people panic and buy. This causes the prices to rise further (classic demand greater than supply) and more people buy .........and so it goes on until the loans aren't repaid, repossession kicks in and the bubble bursts. Now the initial rise in prices might have been caused by something quite innocuous like lunchtime speculative chit chat in a pub - the butterfly flapping its wings! Just as the butterfly might not directly cause a tornado but affect its destination, so the chit chat might not directly cause property speculation but could act as a stimulus to panic buying.

We can theorise all day until the cows come home and if we can't test our theories by re-running history, they are of little value. But what is important is to recognise the limitations of our analysis of the past and prediction of the future in the chaotic environment within which we all live. Returning to the subject of the weather, meteorologists have long since abandoned expending much effort on long range (greater than 7 days) weather forecasts, which were based on past weather patterns and were rarely accurate. So when someone says with an air of confidence 'they say' we're in for a cold winter or a dry hot summer, take it with a pinch of salt! But whilst the weather is accepted by most as chaotic and highly unpredictable, why is it that the financial and business world, which has been proved from experience to be highly chaotic, is regarded as predictable? When stocks and currencies fluctuate on a daily basis, usually by fractions of a percent, analysts come up with all sorts of seemingly plausible reasons and declare with certainty what will happen in the future even though history has proved they don't really know!

I will continue to enjoy life's unpredictability and be amused by the pet theories of the 'experts'. Who knows, one day politicians might not blame the opposition or global economic circumstances beyond their control, for their own failures. They might just point the finger at a harmless and beautiful butterfly!!