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Wednesday, 17 March 2010

Investing By Jerks

Punctuated Equilibrium

Back in the early 1970’s a couple of young biologists came up with an suggestion that profoundly annoyed many of their colleagues and has continued to divide their subject ever since. The idea was called “punctuated equilibrium” and argued that evolution doesn’t develop smoothly and continuously over time but proceeds with long stops and short starts, thus making the chances of finding intermediary forms in the fossil record vanishingly small.

The opponents of this, to non-biological eyes, non-controversial extension to evolutionary theory responded sarcastically that this was “evolution by jerks” invoking the rejoinder that the alternative was “evolution by creeps”. Clearly, the world of the evolutionary life sciences is populated by some seriously adult people. However, the idea of punctuated equilibrium is a powerful one and its applicability to other systems characterised as evolutionary, like the world’s economy, is replete with possibilities. After all, can investing by jerks be any worse than everything else we’ve witnessed?

Another Long Argument

The scientists behind the idea of punctuated equilibrium were Niles Eldredge and Stephen Jay Gould. Subsequently Gould became involved in a series of intellectual spats about the concept up until his death in 2002. Critics included Richard Dawkins, Daniel Dennett and E.O. Wilson which amounts to a fairly serious barrage of opposition given that everyone involved is a committed evolutionist.

Roughly two counterarguments can be discerned. The first is that punctuated equilibrium isn’t really a major idea in its own right, it’s more a minor extension of evolutionary theory which has gained vastly more public attention than it deserves through Gould’s extraordinary ability to make scientific ideas accessible to the general public. Obviously, that’s a bit of a back-handed complement given the opposition.


Secondly, though, is a more interesting debate, which is the argument between adaptationists and their opponents. Adaptationists suggest that (nearly) every feature and trait of biological lifeforms can be explained as an evolutionary adaptation.

Gould was firmly opposed to this idea, arguing that not every feature of every living thing is a direct result of evolutionary pressure. In fact, he went so far as to suggest that pursuing this approach to its ultimate conclusion was to substitute a Creator with evolution, since if you state that natural selection has directly caused every trait without always knowing how they evolved then you have a handy theory for explaining everything that ultimately explains nothing. Opposing him are a wide variety of convinced adaptationists who, even when they can’t convincingly explain the adaptive purpose of any feature, can argue that the history of science shows that this means we just haven’t found the reason yet.

You can get a feeling for the debate in this amusing spat between Gould and Dennett over the latter’s characterisation of the former’s ideas in one of his books on the pages of the New York Review of Books. It’s easy to caricature the positions here, the truth is more nuanced. However, Gould’s belief was that many features of evolutionary systems are accidental emergent side-effects, the opposing view that this is rarely the case.

To Investment Markets and Beyond

These two ideas originating in evolutionary theory, punctuated equilibrium and emergent side-effects, have made their way across from the life sciences to economic theories via recognition that the two systems under description have very similar properties. Both the evolution of life and the development of markets are types of complex, adaptive systems where the agents involved – life forms in the former and people in the latter – modify their behaviour in response to changes in environmental conditions. A mutation of white butterflies to create black ones rapidly appeared during the Industrial Revolution in Britain in response to the life-preserving benefits of being hidden from predators on smoke-blackened trees; institutional investors burned by losses on complex derivatives turn to government bonds.

Given the analogies between these systems a number of commentators have, not unnaturally, wondered if the ideas of punctuated equilibrium and emergent side-effects might also not be applicable to financial markets. Now, if this is true, there’s a fairly nasty undercurrent. Most creatures that have ever been brought into existence are now extinct – only a few percent of the species that have ever been created are still around today, and these are dying out at an unconscionable pace. As Gould argued, the existence of any creature today – not excepting humanity – is the result of an unimaginable run of luck, the equivalent of thousands of coin tosses coming up heads. It’s all contingent on things which need not have happened.

Jerks in Markets

Translated to the world of finance this suggests that rapid changes to the financial ecosystem are bound to damage swathes of investors who simply aren’t equipped to deal with the new reality. As the Ice Age looms and the glaciers surge towards them they simply sit there, tapping the same old trades into their internet terminals.

This isn’t an entirely new idea – in Punctuated Equilibrium and Its Relevance to Investment Markets William W. Priest argues that this is more or less what happens in investment markets when major changes are afoot:
"I believe that the theory of punctuated equilibrium is remarkably applicable to the world of investing. Sudden equilibrium shifts do not only occur within fossil records: they occur within security markets as well. Such shifts occur because of changes in the drivers of real economic growth such as inflation, interest rates, productivity and profits as well as the development of new financial products such as derivatives and their related myriad of applications."
Beyond the Point of Equilibrium

Priest’s thesis is that the financial world is undergoing the equivalent of rapid glaciation, that economic borders across the globe have collapsed and capital has shifted from high cost locations to low cost locations, leaving behind it a vacuum. In the developed world wages have hardly changed since 2000 yet the consumption of its occupants has surged.

Secondly, he thinks that securitization has exposed the world to another possible point of punctuated equilibrium, because of the shift in risk from where it’s understood to where it’s not has simultaneously caused a one-off surge in liquidity as people mortgage up their homes to release equity without realising the damaging deflationary effects of globalisation.

Thirdly, he thinks that the unregulated nature of the hedge funds is likely to cause a problem. Underneath the surface it’s highly probable that these funds are making similar bets such that if an equilibrium point is breached one unintended side-effect will be that they’ll all likely react in the same way – with catastrophic effects for global financial systems as all asset classes suddenly get hit by a liquidity crisis at the same time.

When the Dust Settles

In fact, you’ll probably think that the tense used in the last three paragraphs is wrong and that this is describing in hindsight what has already happened. But it isn’t, because these words were written in May 2007 before the chickens bizarrely took flight and came home to roost.

We’re right in the middle of an unparalleled period of disequilibrium. Nothing is as it seems, and the global imbalances that were caused in the first decade of the twenty first century will take a long time to right themselves. In the meantime the lessons of evolutionary theory tell us that it’s best to be small, to be nimble and not to take too many risks. When the dust of the meteor strike has settled it’ll be those with the evolutionary advantage of capital who are best placed to inherit the mantle of the dinosaurs. When it comes to investment sometimes it’s best to be a jerk.

Punctuated EquilibriumDARWIN'S DANGEROUS IDEA: EVOLUTION AND THE MEANINGS OF LIFEThe Big Short: Inside the Doomsday Machine

Related Articles: Sexual Trading, Cyclical Form, Growth and Fibonacci, Bacteria, Boids and Market Instability

1 comment:

  1. Priest’s thesis is that the financial world is undergoing the equivalent of rapid glaciation

    I agree that we are going through a time of intense change in our understanding of how investing works. I think he misses the most important reason for this -- the development of the Buy-and-Hold Model.

    Buy-and-Hold was the first scientific attempt to understand how stocks work. I view it as a gravely flawed first-draft effort. But I think it is of huge importance that we are moving in the direction of coming to a systematic understanding of markets.

    The mistakes made in the first draft effort may kill us. That's the downside. But what we will learn on the other side in the event that we survive the damage done by the mistakes made in the first draft will be amazing. That's the upside.

    We are today in a race to the finish line to see whether The Next Step is to go over the cliff or to enter The Golden Age of Middle-Class Investing. I have my fingers crossed!