Remember going to the beach as a kid and making a sandpile? Scoop by scoop, you kept adding sand to the top of the pile, trying to add height. But sometimes, the next scoop would result in an avalanche. Did you ever wonder which scoop caused the avalanche, and why?
Well, even if you weren’t this inquisitive as a kid, some people are. In 1987 three physicists, Per Bak, Chao Tang and Kurt Wiesenfeld, developed a computer model to replicate the avalanche behavior of sandpiles. Many of the insights from the BTW sandpile research have found their way into diverse fields, including geology, psychology and economics.
Because their computer program could account for the unique position of individual grains of sand, the BTW sandpile model could identify grains of sand that were in a stable state in the pile (“normal”) and those that were unstable (“critical”). The normal grains were color-coded green, the critical red. This analysis produced a spider-like illustration where the pile was predominantly green, but veined with red sections. Avalanches tended to occur when a new grain of sand hit a red area, but where the additional grain landed was a random event. At a very simplistic level, this meant that avalanches were both foreseeable and random. BTW data also revealed another interesting insight: The longer the time between avalanches, the greater the magnitude of the slide. In contrast, more frequently-occurring collapses tended to produce smaller avalanches.
An Economic Application from the Sandpile:
The Business Cycle is an economic model which identifies fluctuations in production or economic activity over several months or years. While these fluctuations are not fixed as to their length or intensity, they do appear as four distinct stages that occur in a particular sequence. Thus, at any point in time, the economy is in one of the following states:
Contraction – When the economy starts slowing down.
Trough – When the economy hits bottom, usually in a recession.
Expansion – When the economy starts growing again.
Peak – When the economy is in a state of “irrational exuberance.”
Most politicians, economists, bankers and financial commentators accept the validity of the general concepts embodied in the Business Cycle model. The differences come in how these people propose to respond to it. Some wonder if it might be possible to “flatten” the cycle, lowering the peaks and raising the troughs. Others see opportunities to extend the length of the peaks while shortening the troughs. The most optimistic see a utopia where the Business Cycle morphs into a straight line, climbing ever upward.
All of these proposals to manipulate the economy are similar to attempting to place a new grain of sand in precisely the right point so as to avoid an avalanche and add to the pile’s height. In theory, this is possible. In reality, there are so many interconnected variables it’s hard to tell if any “economic stimulus plan” will produce the desired result—which is why some free-market economic thinkers recommend letting the economy run its course through the Business Cycle.
The argument advanced by free-market advocates is that naturally occurring contractions and troughs will be shorter and lesser in magnitude than those that are delayed or manipulated. Just as the more frequent avalanches result in less damage to the sandpile, the long-term economic fallout from these more frequent non-manipulated contractions will be smaller. Again, in the abstract, this makes sense. But most of us have an aversion to pain, financial or otherwise. Unless faced with the absolute necessity to face the music, we will choose to delay a day of reckoning. But at some point, we choose (or are compelled) to make a decision to cut our losses, retrench our position and chart a new course.
Relying on Luck or Logic?
In regard to the national economy and the Business Cycle, an individual has no ability to influence either the decision-making or the outcomes. But individuals can make decisions about their personal financial circumstances. One of their choices may be to cut their losses from ill-advised decisions, and redirect their financial efforts. Another might be to keep on the same course, hoping the weaknesses in their financial condition will not result in a financial avalanche. The question: Which outcome will be more palatable: a small step back today, or continuing on with the risk of a bigger adjustment later? For example…
Does it make sense to continue maximum contributions to a 401(k) if credit card debt has become unmanageable? Maybe debt reduction should become a higher priority, even at the expense of retirement saving.
Should you let go of investments that remain depressed, instead of holding them, in the hope that you will eventually break even? Moving to a more conservative allocation might diminish up-side opportunities, but result in steady growth in accumulation.
Life itself has some inherent instabilities, but while you can never eliminate the impact of random events, you have some control over the structure of your individual “sandpiles.” If your financial sandpile has structural weaknesses (too much debt, not enough saving, incomplete estate planning, poor risk management), every day you don’t address the issues is another grain of sand building toward a bigger avalanche. If you are hoping to get lucky, maybe you will and maybe you won’t.
Conversely, it must be acknowledged that building a better financial sandpile cannot guarantee success—unforeseen random factors will still come into play. But handling a small avalanche is better than being overwhelmed by a large one. Don’t confuse luck with good planning. Strengthen your good fortune by Stabilizing your “Sandpile.”
Elozor Preil is Managing Director at Wealth Advisory Group and Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). He can be reached at epreil_wagroupllc.com
See www.wagroupllc.com/epreil for full disclosures and disclaimers. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.
By Elozor M. Preil
