#96 Strategy to Increase Ergodicity: Reduce Exposure to Irreversibility

In this  post we will discuss different ways to manage non-ergodicity by reducing your exposure to irreversibility.

Barbell Strategy

The barbell strategy consists of exposing most of yourself to safe activities and a tiny bit of yourself to risky ones with high upside. Note the emphasis on a tiny bit - if you play the Russian Roulette you are exposing yourself "completely" to the risk of dying - hence should be avoided. The point of the barbell strategy is to pursue risky activities in a way that caps the downside. By reducing the amount exposed to risk, it prevents a single loss, or a short series of losses, from constituting a game over. This strategy acknowledges that in most contexts, a small exposure to high upside brings higher returns than a moderate exposure to moderate upside.

If you apply the barbell strategy in the investing world - you will allocate one part of your wealth to non-risky assets and another part of your wealth to risky assets with high upside. Note: An activity with a tiny chance of a ruinous outcome is not considered "limited-downside"

Kelly Criterion

The Kelly criterion is a formula that determines the optimal theoretical size for a bet when the returns are known (See Wikipedia for the formulas). Two intuitions can be derived from the Kelly Criterion - don't go all-in with your bets and payoffs should determine the relative size of the bet.

A layman's summary of the Kelly Criterion - risk exposure must depend on payoffs and anyway be limited. Apart from its use in investing and gambling activities, you can use it to determine how to spend your time - spend more time on projects with higher upside and limit committing all of your time to a single project for an extended period of time.

Precautionary Principle

The precautionary principle holds that we should not take risks that endanger the whole, no matter how unlikely. The precautionary principle does not say avoid all risks - just those that can destroy the whole.

We cannot use cost-benefit analysis with risks that can kill the ecosystem. If we take enough risks of this type with a positive cost-benefit analysis, we are guaranteed to kill the ecosystem. Do not expose the whole to irreversibility, no matter how attractive the payoffs.

Natural Selection and Fractalization

In nature those who are fit thrive and the unfit perish. This plays out in business as well - the best companies thrive and grow, the worst ones go out of business. Natural selection is inevitable for companies, but they can decide whether it acts on them or within them. Companies can avoid going out of business by killing projects that go on endlessly, firing employees who are not performing, and exiting non-profitable businesses.

If you see a business as a hierarchy of layers you decrease the ergodicity of the lower layers (business units, projects and employees) to increase that of the higher ones (hence the term fractalization to indicate that this principle can be applied fractally)

This post is a summary from a chapter in Luca Dellanna's book - Ergodicity