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Friday, 27 February 2009

Darwin's Stockmarkets

Reagan's Revolution

Ronnie Reagan, when asked for his beliefs about the Theory of Evolution, shrugged and replied; “Hey, it’s only a theory”. Which it is, I guess, in the same way that the Theory of Gravity is “only a theory” although somehow I doubt my pet dog will start exhibiting signs of weightlessness anytime soon. In fact Darwin’s great intellectual jump wasn’t evolution itself but an insight into what underlay the concept – an idea applicable to financial markets and sobering in what it suggests about our ability to predict anything, let alone something as complex as the screamingly mad world of finance.

Paley's Watchmaker

Prior to Darwin evolutionists had been stymied by their inability to refute something known as “The Argument from Design”. Most famously this was expounded by the English theologian William Paley in his allegory of the watchmaker. The argument goes like this: if you were walking down a path, happened upon a watch and picked it up to examine its inner workings would you not leap to the obvious conclusion that this device must have a designer? In the same way, therefore, if you happened upon a living creature – a frog, say – and examined it in a similar manner you would, once you’d got over the nasty business of opening it up and feeling disappointed because last time you found a watch and now all you have is a dead frog oozing gunk all over your hand, also conclude that it must have a maker. Nothing that complicated could arise without the direction of a higher authority, surely?

At root this is about complexity: before Darwin scientists could see the links between animals but couldn’t figure out a method by which such complexity could arise without some control and command process. Much like the Russian state planner, who (allegedly) came to London in the wake of the fall of the Berlin Wall and wanted to know who was responsible for ordering all the bread, most nineteenth century scholars couldn’t conceive of any other way than a Creator of producing complex creatures.

Natural Selection = Natural Advantage

Darwin’s key insight was that in a world of finite resources (e.g. food, mates, million dollar bonuses, Ferraris, mortgages) any animal that had even a small advantage over another would be more successful at accessing those resources and in breeding and passing on those advantages. Even though he couldn’t figure out the mechanism behind this process of natural selection – genes and genetic mutation were unknown to him – what he’d done is identify a way in which natural complexity might arise without direction due to this underlying competition for resources.

We know that Darwin’s influences included the leading economic thinkers of his time. There’s a striking resemblance between Darwin’s natural selection and Smith’s “invisible hand” which isn’t surprising because what we see in the markets of the world everyday is natural selection in action. We also see a contingent complexity arising and it’s that combination of complexity and contingency that makes investing such a complete lottery for the unprepared.

Contingency – that the current state of the world could have been different had things happened even slightly differently – was hard for Darwin’s Victorian peers to accept because it meant that human status at the top of the pile was not pre-ordained and was down as much to luck than any God-given right. Now we know that dinosaurs ruled the planet until an asteroid strike wiped them out and allowed the rise of a new generation of animals who included our fragile ancestors. Our own genes show that the entire human population was, at various times, whittled down to a handful of survivors. So, is our presence on this planet today destiny or luck?

Are Business Leaders Skilled or Lucky?

In the same way we can consider the corporations of today. Is Bill Gates a genius or did he strike lucky? Or maybe a bit of both? The great Australian cricketer Richie Benaud states that being a successful cricket captain is 90% luck and 10% skill. It helps to be lucky, he said, but don’t try it without the skill. Sounds like many of the captains of industry to me.

One of the problems is that, with hindsight, everything looks obvious. It’s really, really difficult to see how things could have been any different than they are and that leads us to ascribe superpowers to mortal men. Think of Alan Greenspan – not so long ago he was a superhero for successfully leading the world through a series of financial crises. Now he’s a fallen figure, the man who mortgaged the future of the world economy through measures that simply delayed the onset of financial problems until they were almost too big to handle. For all the commentators that point this out now, though, how many of them were making the same statements five years ago? Hindsight makes pygmies look like giants.

To Make Money Find Your Feminine Side

Self-deceit about the past is a another common human trait. Arguably it’s central to our construction of a core identity – the belief that the person we are now is, in some fundamental way, the same person we were a day, a week, a year, a decade ago. Yet anyone who keeps a diary and goes back to it years after knows that shocks lie in store: we change, we are the flowing river not the immovable rock. So if the complexity of markets is Darwinian in nature with companies ferociously competing against each other, with some getting lucky and some unlucky and if we can’t even trust our own judgements about ourselves how can the hapless investor hope to make an honest buck?

Recognising the issues is a start, because overconfidence is a massive destroyer of value for investors. Men, it seems, are particularly prone to ascribing themselves abilities they don’t have – so successful investments are down to skill and unsuccessful ones to unpredictable bad luck or someone else’s failure - see, for example, Barber & Odean (1). Women seem more able to resist the temptation to big up their own books. Whether this is genetic or social conditioning is unclear, but the basic message to investors seems to be: be more female. Which doesn’t give all you guys carte blanche to put on high heels and lipstick. Well, unless you really want to. I’m pretty open minded about most things other than levitating dogs and randomly opening up hapless frogs in a futile quest for free timepieces.

Trade Less, Make More

What does all this mean for the investor? Less trading for a start: if markets are genuinely Darwinian then their constituents will mutate under the pressure of natural selection and today’s failure is more than likely to be tomorrow’s success (although also you need to be able to tell the difference between the temporarily fallen angel and the permanently earthbound demon – psychology can only complement stock analysis, it can’t replace it). Unlike animals a corporation doesn’t have to produce offspring to mutate, it can and often will change itself under commercial pressure. The oft-quoted and observed phenomena of mean reversion is simply the overt expression of this trend: today’s successful company is more likely to be tomorrow’s failure and vice-versa.

Unlike Darwin we have the tools and knowledge to figure out what underlies natural selection in markets. It’s not a perfect science and because people are involved we must hope it never will be – I certainly don’t want to live in a world in which my every action is predicted. As for Charles Darwin, he died not knowing how the mechanisms that underlie natural selection work even though, by the time of his death, an obscure Austrian monk called Gregor Mendel had started to unpick the nature of genes, inherited characteristics and the possibility of mutation though experiments breeding pea plants.

It’s a fact of contingent history that Mendel sent his paper to Darwin. At the time of Darwin’s death it was sitting in a bookshelf a few feet away from the desk in Down House at which he did so much of his work, its pages uncut and its contents unread. Destiny or luck?

(1) "Boys will be Boys: Gender, Overconfidence, and Common Stock Investment" Brad Barber and Terrance Odean, Quarterly Journal of Economics, February 2001, Vol. 116, No. 1, 261-292

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