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The Ergodic Capital Problem (explained to a 10 yr old that gets it)



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Imagine you have a jar full of different coloured marbles. You want to pick out the best ones each time you reach into the jar. Now, what if every time you pull a marble, some of the marbles change colour or disappear? This makes it harder to know what you'll get next time, right?

This is similar to the ergodic capital problem. In investing, people often assume that if they make the same choice over and over, things will even out and work out okay. But in reality, the world isn’t like that. Some events can change things forever—like a big storm that ruins all the crops, or a new technology that makes old businesses disappear. These changes don’t go back to normal, and we can't always predict them (these are the non-ergodic dynamics of business!).

Just like with the marbles, investors can’t always count on things balancing out. Some choices can lead to losing all their marbles because the system doesn’t always work the same way every time. It’s as if they think they can keep pulling marbles safely, but one day, a huge change happens, and they lose everything because they didn’t prepare for that possibility.

How do we know that this is in fact a burning problem and we have it?!

The ergodic capital problem has significantly influenced and affected our economy by contributing to systemic fragility, environmental degradation, and increasing inequality. Here’s how this issue manifests:

1. Short-Termism and Risk Blindness
In traditional finance and investment, the assumption that systems are ergodic leads to short-term thinking. Investors and businesses often make decisions based on short-term returns, expecting that market fluctuations will smooth out over time. However, the non-ergodic nature of many systems (where early shocks or disruptions can permanently affect outcomes) is overlooked.

Impact on the Economy:

Financial Crises: This mindset contributed to the 2008 financial crisis. Banks and investors believed risks were distributed evenly and could be managed, without considering that housing market crashes or debt defaults could cause cascading failures.
Boom-and-Bust Cycles: Markets driven by short-term profit incentives have historically experienced boom-and-bust cycles, creating instability in sectors like real estate, tech, and commodities.

2. Overlooking Environmental and Social Risks
Ergodic assumptions in economic and financial systems tend to ignore long-term, systemic risks such as climate change, social inequality, and resource depletion. In a non-ergodic system, where certain risks can accumulate and compound over time, ignoring these risks is particularly dangerous.

Impact on the Economy:

Environmental Degradation: The drive for short-term profits has led to over-extraction of natural resources, deforestation, and pollution. This has resulted in long-term, often irreversible damage to ecosystems. The ongoing climate crisis is a direct consequence of capital flows prioritizing short-term returns at the expense of sustainability.
Inequality: Focusing on capital maximization in the short term often leads to wealth concentration in the hands of a few, while large segments of the population experience economic hardship. Wealth inequality has been rising for decades, leading to social unrest and political instability in many countries.

3. Fragile Economic Structures
Non-ergodic systems are highly sensitive to rare but significant events (so-called "black swans"). By assuming ergodic conditions where they don't exist, rather than actively and strategically creating them, companies and economies fail to prepare for low-probability but high-impact risks, such as pandemics, natural disasters, or geopolitical crises.

Impact on the Economy:

COVID-19 Pandemic: The COVID-19 pandemic exposed the fragility of global supply chains and economic systems. Companies and governments were unprepared for such a large-scale shock, leading to massive economic disruptions, unemployment, and increased debt.
Systemic Fragility: The growing interconnectedness of global supply chains and financial markets has made economies more susceptible to shocks. A disruption in one part of the world can have a ripple effect, leading to cascading failures across industries and borders. The 2021 supply chain crisis is an example of how fragile systems can break down under unexpected stress.

4. Misallocation of Capital
The ergodic capital problem encourages the misallocation of resources. Traditional economic models tend to focus on maximizing returns in the present, leading to underinvestment in areas crucial for long-term resilience, like education, infrastructure, healthcare, and clean energy.

Impact on the Economy:

Underinvestment in Sustainability: Sectors that could create long-term value (like renewable energy, regenerative agriculture, or social welfare) are often underfunded because they don't offer immediate returns. This slows down progress toward sustainability and perpetuates reliance on fossil fuels and extractive industries.
Stagnant Wages and Job Losses: Companies optimizing for short-term profits often cut costs by automating jobs or outsourcing labor, leading to stagnant wages and job losses. This diminishes consumer purchasing power, contributing to economic stagnation over time.

5. Increased Systemic Risk
Financial institutions, corporations, and even governments often fail to account for the inherent uncertainty and instability of non-ergodic systems. The assumption that markets will self-correct and risks will average out over time leaves the economy vulnerable to shocks.

Impact on the Economy:

Financial Instability: The failure to account for systemic risks has led to periodic financial crises, such as the Dotcom bubble, the housing market crash, and other speculative bubbles. These events destroy wealth, lead to unemployment, and create long-lasting economic scars.
Economic Inefficiency: When capital is misallocated, it can lead to bubbles in speculative sectors while leaving critical areas underfunded, exacerbating inefficiency in the economy. For example, while tech valuations surged in the last decade, sectors like healthcare and infrastructure, essential for societal resilience, received far less investment.

6. Failure to Foster Resilient Economic Systems
An economy operating under ergodic assumptions often fails to develop the capacity to withstand and adapt to shocks. Economic models that ignore the unpredictability and path-dependence of real-world systems don’t foster resilience or adaptability.

Impact on the Economy:

Lack of Economic Diversity: Non-diverse economies are more susceptible to collapse when one sector faces a downturn. For example, economies heavily reliant on oil revenues may experience massive economic dislocation when energy markets shift toward renewables.
Polarization of Wealth: Capital tends to accumulate in financial markets that reward short-term returns, leaving local and circular economies underfunded. This has contributed to the hollowing out of middle-income jobs and the increasing polarization of wealth between a small number of asset owners and the broader population.

Moving Forward: Addressing the Ergodic Capital Problem
To mitigate the impacts of the ergodic capital problem, there is a growing movement towards ergodic investing or anti-fragility-based approaches that Evolutesix is spearheading. These approaches focus on:

  • Building resilient and adaptive economic systems that can withstand shocks and even grow stronger from them.
  • Investing in long-term sustainability by prioritizing regenerative economies, that are designed to be inclusive of all capitals, in both competition and cooperation for ecosystem health.
  • Embracing complex systems thinking by recognizing the interconnectedness of economic, social, and environmental factors.

These strategies involve acknowledging the non-ergodic nature of our world and moving toward an economy that values long-term resilience, adaptability, and shared prosperity over short-term profit maximization.

For the serious, no BS, investor
In a world of growing uncertainty, traditional portfolio investing isn’t just falling behind—it’s putting your wealth at risk. The world urgently needs you to stop relying on outdated strategies and start applying a proven approach that thrives in volatile markets. Your work starts here.
  • Patrick Kiash

    6 w

    Thankyou for reminding us that we need to prioritize long-term sustainability and resilience in investing.i find it very worth and educative.

    3
    • Kelvin Thuranira kaberia

      6 w

      These changes don’t go back to normal, and we can't always predict them

      3
      • Ingmar Rentzhog

        6 w

        Geeat post! Very good way to explain it!

        4
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