The market crash of 1987 caught most scholars, economists, and investment professionals by surprise. Nowhere in the classical, equilibrium-based view of the market so long considered inviolate was there anything that would predict or even describe the events of 1987. Then, some thirty years later, we learned this hard lesson all over again. The stunning events of 2007–2009 and their devastating dominoes only served to reinforce this unsettling sense of being blindsided by something wholly unpredictable. This double failure of the existing theory left open the potential for competing theories. Chief among them was the belief that the market and the economy are best understood from a biological perspective.
Turning to biology for insight into finance and investing may at first seem a startling move, but just as we did in our study of physics, we focus here on just one core idea from the field of biology: evolution. Whereas in nature the process of evolution is one of natural selection, seeing the market within an evolutionary framework allows us to observe the law of economic selection.
The concept of evolution is not the sole intellectual franchise of any one mind. As far back as the sixth century B.C.E., the possibility of species developing in different forms had been expressed by Greek and Chinese philosophers. Yet today, the evolutionary principle is firmly associated with one individual, a man whose ideas triggered a scientific revolution every bit as profound as that emanating from the work of Sir Isaac Newton a century and a half earlier.
Charles Robert Darwin was born in Shrewsbury, England, in 1809, into a family of scientists. His paternal grandfather was the physician and scientist Erasmus Darwin, and on his mother’s side, his grandfather was the famous potter Josiah Wedgwood.1
His father, Robert, also a respected physician and very forceful personality, insisted that Charles study medicine and enrolled him in the University of Edinburgh. Darwin was uninterested. He found the classroom studies boring and became violently ill at the sight of surgery performed without anesthesia. The natural world was far more fascinating to him, and the young Darwin spent many hours reading geology and collecting insects and specimens.
Realizing his son would never become a physician, Robert Darwin sent Charles to Cambridge University to study divinity. Once again a less than stellar student, he nonetheless earned a bachelor’s degree in theology. More significant than the formal course of study were the associations he formed with several of the Cambridge faculty. The Reverend John Stevens Henslow, professor of botany, permitted the enthusiastic amateur to sit in on his lectures and to accompany him on his daily walks to study plant life. Darwin spent so many hours in the professor’s company that he was known around the university as “the man who walks with Henslow.” After graduation, Darwin joined a geological trip to Wales, an experience that moved him to consider a career as a geologist. But when he returned home from Wales, Darwin found waiting for him a letter that would change his life forever.
Professor Henslow wrote to say that he had recommended Darwin for the position of naturalist on a naval expedition. HMS Beagle, under the command of Captain Robert FitzRoy, was soon to leave on a voyage of scientific exploration with two purposes: to continue the process of charting the coast of South America, and to add to the investigation of longitude by taking a series of chronological readings. It would require sailing completely around the world, a trip of at least two years (as it turned out, the trip took five years). The position of naturalist carried no salary—in fact, the naturalist would have to pay his own expenses—but Darwin was thrilled at the prospect.
He almost did not make the journey. Faced with his father’s strong objections, Charles at first declined the offer. Fortunately, Charles’s uncle, Josiah Wedgwood II, whom Dr. Darwin respected, intervened and convinced his brother-in-law that it was a splendid opportunity for the young man. And thus, when the Beagle set sail from Plymouth, England, on December 27, 1831, Charles Darwin was aboard, charged with the responsibility of collecting, recording, and analyzing all of the flora and fauna and every other aspect of natural history that would be encountered. He was twenty-two years old.
Always more comfortable on land than sea, Darwin was frequently seasick, and during the voyage he often kept to himself, reading from the ship’s library and his own personal collection of scientific texts. But whenever the ship landed, he plunged eagerly into exploring the local environment. What we know to be his most significant observations occurred fairly early in the trip, on the Galapagos Islands, near the equator on the Pacific side of South America, about six hundred miles west of Ecuador. This island group would prove to be the perfect laboratory for studying the mutability of species.
Darwin, the amateur geologist, knew that the Galapagos were classified as oceanic islands, meaning they had risen from the sea by volcanic action with no life forms aboard. Nature creates these islands and then waits to see what shows up. An oceanic island eventually becomes inhabited but only by forms that can reach it by wings (birds) or wind (spores and seeds). In the Galapagos, Darwin surmised that the tortoise and marine iguana, swimmers capable of staying under water for long periods of time, could have made the long journey from South America, possibly attached to floating debris pulled along by the current. He also figured that other animals he observed had been brought to the islands by earlier sailors and adventurers. But much of what he saw in the island group puzzled and intrigued him.
Darwin was particularly fascinated by the presence of thirteen types of finches. He first assumed these Galapagos finches, today called Darwin’s finches, were a subspecies of the South American finches he had studied earlier and had most likely been blown to sea in a storm. But as he studied distribution patterns, Darwin observed that most islands in the archipelago carried only two or three types of finches; only the larger central islands showed greater diversification. What intrigued him even more was that all the Galapagos finches differed in size and behavior. Some were heavy-billed seedeaters; others were slender billed and favored insects. Sailing through the archipelago, Darwin discovered that the finches on Hood Island were different from those on Tower Island and that both were different from those on Indefatigable Island. He began to wonder what would happen if a few finches on Hood Island were blown by high winds to another island. Darwin concluded that if the newcomers were preadapted to the new habitat, they would survive and multiply alongside the resident finches; if not, their number would ultimately diminish. It was one thread of what would ultimately become his famous thesis.
When Darwin returned home in 1836, he was enthusiastically welcomed into England’s scientific community. He was immediately made a fellow of the Geological Society and three years later was elected to the Royal Society. He quickly settled into work. Publicly, Darwin was busily preparing the publication of his many geological and biological discoveries. But privately, he was also constructing a new theory.
Reviewing his notes from the voyage, Darwin was deeply perplexed. Why did the birds and tortoises on some islands in the Galapagos resemble the species found in South America while those on other islands did not? This observation was even more disturbing when Darwin learned that the finches he brought back from the Galapagos belonged to different species and were not simply different varieties of the same species, as he had previously believed. Darwin also discovered that the mockingbirds he had collected were three distinct species and the tortoises represented two species. He began referring to these troubling questions as “the species problem,” and outlined his observations in a notebook he later entitled “Notebook on the Transmutation of the Species.”
Darwin now began an intense investigation into the species variation. He devoured all the written work on the subject and exchanged voluminous correspondence with botanists, naturalists, and zookeepers—anyone who had information or opinions about species mutation. What he learned convinced him that he was on the right track with his working hypothesis that species do in fact change, whether from place to place or from time period to time period. The idea was not only radical at the time, it was blasphemous. Darwin struggled to keep his work secret.
As he continued to study and think, Darwin was increasingly certain that evolution was taking place, but he did not yet understand how. It wasn’t until 1838 that he was able to put the pieces together. In the fall of that year, Darwin began to read Essay on the Principle of Population by the British economist Thomas Malthus. After exploring the relationship between the food supply and human population, Malthus concluded that population was increasing geometrically while the means of subsistence (food production) progressed arithmetically. Thus population growth would always outrun the growth of food supplies and populations would grow until checked by war, famine, or disease.
Darwin saw an immediate parallel between Malthus’s work and the unanswered questions about animal and plant populations. Malthus’s theory decreed that a limited food supply would force an increasing population into a permanent struggle for survival. From his years of observation, Darwin recognized the Malthusian process in the animal world. “Being well prepared to appreciate the struggle for existence which everywhere goes on from long-continued observation of the habits of animals and plants,” he wrote in his notebook, “it at once struck me that under these circumstances, favorable variations would tend to be preserved and unfavorable ones to be destroyed. The result of this would be the formation of new species. Here, then, I had at last got a theory—a process by which to work.”2
The originality of Darwin’s theory lay in the idea that the struggle for survival was occurring not only between species but between individuals within the same species. If having a longer beak, for example, increased a bird’s chances of survival, then more birds with long beaks would be more likely to pass this advantage on. Eventually, the longer beak would become dominant within the species.3 By this process of natural selection, Darwin theorized, favorable variations are preserved and transmitted to succeeding generations. After several generations, small gradual changes in the species begin to add up to larger changes—thus, evolution occurs.
In 1842, Darwin had completed a brief outline of his new theory, but resisted publication. Perhaps sensing the furious controversy the theory would generate, he insisted on developing further documentation. Then on June 18, 1858, Darwin received a paper from the naturalist Alfred Russel Wallace that summarized perfectly the theory Darwin had been working on for twenty years. For advice, Darwin called on two close colleagues, the geologist Robert Lyell and the botanist Joseph Hooker, and they decided to present the work of both men in a combined paper. The following year, Darwin published On the Origin of Species by Means of Natural Selection, or the Preservation of Favoured Races in the Struggle for Life. The book sold out on the first day, and by 1872, The Origin of Species, as it was popularly called, was in its sixth edition.
Darwin had written the book of the century—perhaps, said the noted evolutionary biologist Richard Dawkins, the book of the millennium. “The Origin changed humanity, and of all life, forever,” Dawkins wrote.4 It also changed our view of other areas of knowledge, including economics, and that is the focus in this chapter.
In the years following Darwin’s masterpiece, European intellectuals were fascinated with the theory of natural selection; it swirled through conversations, lectures, and writings in many fields of study. Inevitably, the concept of evolutionary change attracted the attention of economists as well.5
The first luminary was Alfred Marshall, the leading economist in Britain (and therefore, some might argue, the world) from the last decade of the nineteenth century until his death in 1924. Marshall’s magnum opus is Principles of Economics, first published in 1890 and revised and expanded seven times afterward. As a comprehensive review of the development of economic thought, it has few equals, and in fact the eighth edition is still used as an important text in many college curricula.
Marshall makes another appearance in our chapter a little later on. For the moment, I point you to the title page of the first edition of his book. Below the title, below the author’s name and university affiliation, and below a line that poignantly proclaims this as Volume 1, is this Latin phrase:6
Natura non facit saltum.
Marshall’s audience needed no translation, but today most of us do. “Nature does not make leaps.” Darwin himself used the exact same motto in The Origin of Species. So with this homage, Marshall is hinting that he aligns himself with the intellectual revolution triggered by Darwin’s work and perhaps also that he sees virtue in viewing economics through a Darwinian prism. His real intention is a tantalizing puzzle for us today, for Marshall was never fully explicit about his position.
Less than two decades after Marshall’s text first appeared, a new figure in economic study made an impressive debut. In 1908, at the young age of twenty-five, Austrian-born Joseph Schumpeter, educated in both economics and law, published his first book, titled The Nature and Essence of Economic Theory. In it, he sought to differentiate the conventional static view of the economy with his more dynamic theory.
In that first book, Schumpeter advanced the argument that economics is essentially an evolutionary process. He expanded that theme in his next book, The Theory of Economic Development (1911), and continued to develop it throughout his life.7 In fact, Christopher Freeman, a twentieth-century British economist who studied Schumpeter extensively, comments: “The central point of his whole life work is that capitalism can only be understood as an evolutionary process of continuous innovation and creative destruction.”8
Schumpeter’s dynamic economic process was composed of three principal elements: innovation, entrepreneurship, and credit. At the heart of his theory is the idea that the search for equilibrium is an adaptive process. In that process, innovators are the change agents. All changes in the economic system start with innovation.
Innovation, said Schumpeter, is the profitable application of new ideas, including products, production processes, supply sources, new markets, or new ways in which a company could be organized. Whereas standard economic theory believed progress was a series of small incremental steps, Schumpeter’s theory stressed innovative leaps, which in turn caused massive disruptions and discontinuity—an idea captured in Schumpeter’s famous phrase “the perennial gale of creative destruction.”
But all these innovative possibilities meant nothing without the entrepreneur who becomes the visionary leader of innovation. It takes someone exceptional, said Schumpeter, to overcome the natural obstacles and resistance to innovation. Without the entrepreneur’s desire and willingness to press forward, many great ideas could never be launched. Lastly, Schumpeter explained, great innovations led by great entrepreneurs can thrive only in certain environments. Such things as property rights, stable currencies, and free trade are all important environmental factors, but credit is paramount. Without access to credit, the ability to promote innovation would be hamstrung.
In 1907, while Schumpeter was still gathering his thoughts for The Nature and Essence of Economic Theory, he visited the celebrated economist Alfred Marshall in Cambridge.9 At that time, Marshall was sixty-five years old and in declining health. Schumpeter knew that Marshall was intrigued with Darwin’s theory of evolution and was eager to discuss it.
For some time Marshall had privately chided his colleagues for not recognizing that economic phenomena more closely resembled biological processes than the standard mechanized theory. But he was ambiguous about publicly advancing a radically new theory. When Schumpeter told Marshall he intended to promote a biological interpretation of economics, Marshall turned cautious. As he was leaving, Schumpeter commented that their conversation had cast him “as indiscreet lover bent on an adventurous marriage and you a benevolent old uncle trying to persuade me to desist.” Marshall replied in good humor, “And this is as it should be. For if there is anything to it, the uncle will preach in vain.”10
Thirteen years after their meeting, the eighth and final edition of Principles of Economics (1920) was published. Here, for perhaps the first time, Marshall clearly and eloquently presented his ideas on evolutionary economics. In the preface, he wrote:
The Mecca of the economist lies in economic biology rather than in economic dynamics. But the biological conceptions are more complex than those of mechanics; a volume on Foundations must therefore give a relatively large place to mechanical analogies; and frequent use is made of the term “equilibrium,” which suggests something of a statical analogy. This fact, combined with the predominant attention paid in the present volume to the normal conditions of life in the modern age, has suggested the notion that its central idea is “statical,” rather than “dynamical.” But in fact it is concerned throughout with the forces that cause movement: and its key-note is that of dynamics, rather than statics.11
I have always wondered why the biological view of economics, conceived over one hundred years ago, has not yet reached the top rung of academic support. It may be, as Marshall wrote, “biological conceptions are more complex than mechanics.” It may also be that a biological interpretation of economics is just now entering the “revolutionary” phase of scientific development.
Fifty years ago, Thomas Kuhn wrote a landmark book titled The Structure of Scientific Revolutions ([1962] 1970). In it, he challenged the conventional view that scientific progress moves in a pedestrian fashion as a series of accepted facts and theories. Kuhn believed there are times when advancement occurs only by revolution.
Under “normal science,” he explains, puzzles are solved within the context of the dominant paradigm. As long as there is a general consensus about the paradigm, normal science continues. But what happens when anomalies appear?
According to Kuhn, when an observed phenomenon is not adequately explained by the dominant paradigm, a new competing paradigm is born. Scientists left with an ineffectual model go to work on developing a new theoretical outline. Although you might think the transition from old paradigm to new is peacefully led by the collective who are in the pursuit of truth, Kuhn tells us just the opposite happens—hence the term “revolution.”
Proponents of the dominant paradigm, when confronted with a new and alternative paradigm, are left with two choices. They can jettison their long-held beliefs and divorce themselves from a lifelong intellectual and professional investment, or they can stand and fight. In the second case, we have what is known as a “paradigm collision,” and the tactics for dealing with it are straightforward. First, you seek to discredit the new paradigm in any manner possible; then you begin to repair the dominant paradigm so it better explains the environment. For example, when the geocentric view of the solar system was challenged by Copernicus’s evidence that the earth was not the center of the universe, adherents to Ptolemy’s Almagest simply added orbital rings to his elliptical spheres to explain away the anomalies. When that didn’t work, they threw Copernicus in prison until he recanted his theory.
In the midst of a paradigm collision, the scientific community bifurcates.
The older entrenched group seeks to defend the primary paradigm while others seek to institute a new paradigm. Kuhn tells us that once this polarization occurs, “political recourse fails.” Although intense intellectual combat is the norm when two competing paradigms collide, there is another, more subtle way, which can ultimately settle the matter—time.
Kuhn notes that the scientific revolutionaries are often “either very young or very new to the field whose paradigm they change.” They have very little intellectual capital committed to the older primary paradigm and are more “likely to see that those rules no longer define a playable game and [work] to conceive another set that can replace them.”12 If the new paradigm is indeed robust, over time it will attract more scientists. If the older paradigm cannot compete, lacking any new recruits it will slowly fade away. It is, we might say, undergoing a kind of evolution.
Perhaps we should forgive the economists of the last one hundred years for not fully embracing the idea of evolutionary economics. After all, evolution itself is not easily recognizable. Darwin’s evolution was steady, slow, and continuous. Biologists call this gradualism. The beaks of Darwin’s finches or the stripes of a tiger were not altered in a few short years but gradually, over hundreds if not thousands of years. Likewise, a business owner who operates in the same industry year after year may not experience any change. If economic transformation is not easily noticeable, how can we then blame the economist who overlooks it? Seen from this perspective, Marshall would be a gradualist.
But in other cases, change can occur swiftly and dramatically. Biologists call this “punctuated equilibrium.” For a long period of time there is very little change, then suddenly a few huge changes can occur—perhaps the result of DNA mutations or a dramatic alteration of the environment. This is Schumpeter’s evolution. In his world, change occurs very rapidly then settles down again for a period of steady, slow, but continuous alteration.
But no matter its pace, we must remember there is always change. And this is why we must leave Newton’s world and embrace Darwin’s. In Newton’s world, there is no change. You can run his physics experiments thousands of times for thousands of years and always get the same result. But not so with Darwin and not so with economics. Companies, industries, and economies may mark time with no discernible changes, but inevitably they do change. Whether gradually or suddenly, the familiar paradigm crumbles.
Brian Arthur, formerly at Stanford University and a visiting professor at the Santa Fe Institute, was one of the first modern economists willing to take a fresh look at how economics really works. Trained in classical economics, Arthur immersed himself in the teachings of Marshall and Samuelson and in particular the equilibrium of markets—the stability of supply and demand. But the world described by the classical economists was not the same world Arthur saw. No matter how hard he tried to embrace the teachings of stability, he could see only instability. The world was constantly changing, thought Arthur. It was full of upheavals and surprises. It was continually evolving.
In November 1979, Arthur began to record his observations in his personal notebook. One page, which he entitled “Economics Old and New,” he divided into two columns in which he began to list the characteristics of both concepts. Under “Old Economics,” Arthur listed investors as identical, rational, and equal in ability. The system was devoid of any real dynamics. Everything was in equilibrium. Economics was based on classical physics under the belief that the system was structurally simple. Under “New Economics,” Arthur wrote that people were separate and different in ability. They were emotional. The system was complicated and everchanging. In Arthur’s mind, economics was not simple but inherently complex, more akin to biology than physics.
A soft-spoken Irishman, Arthur confesses he was not the first to think about economics in this way, but he was most assuredly the first to confront it.
It was the Nobel Prize–winning economist Ken Arrow who first introduced Brian Arthur to the close-knit group of scientists working at the Santa Fe Institute. Arrow invited Arthur to attend a conference of physicists, biologists, and economists at the institute in the fall of 1987 to present his latest research. The conference was organized in the hope that the ideas then percolating within natural sciences, namely “the science of complexity,” would help stimulate new ways to think about economics.13 Common to the study of complexity is the notion that complex adaptive systems operate with multiple elements, each adapting or reacting to the patterns the system itself creates. Complex adaptive systems are in a constant process of evolving over time. These types of systems are familiar to biologists and ecologists, but the group at Santa Fe thought that perhaps the concept should be expanded, that maybe now the time had come to include the study of economic systems and stock markets within the overarching idea of complexity.
Unshackling themselves from the classical teachings, the Santa Fe group was able to point out four distinct features they observed about the economy.
1. Dispersed interaction: What happens in the economy is determined by the interactions of a great number of individual agents all acting in parallel. The action of any one individual agent depends on the anticipated actions of a limited number of agents as well as on the system they cocreate.
2. No global controller: Although there are laws and institutions, there is no one global entity that controls the economy. Rather, the system is controlled by the competition and coordination between agents of the system.
3. Continual adaptation: The behavior, actions, and strategies of the agents, as well as their products and services, are revised continually on the basis of accumulated experience. In other words, the system adapts. It creates new products, new markets, new institutions, and new behavior. It is an ongoing system.
4. Out-of-equilibrium dynamics: Unlike the equilibrium models that dominate the thinking in classical economics, the Santa Fe group believed the economy, because of constant change, operates far from equilibrium.
An essential element of complex adaptive systems is a feedback loop. That is, agents in the system first form expectations or models and then act on the basis of predictions generated by these models. But over time these models change depending on how accurately they predict the environment. If the model is useful, it is retained; if not, the agents alter the model to increase its predictability. Obviously, accuracy of predictability is a paramount concern to participants in the stock market, and we may be able to achieve broader understanding if we can learn to view the market as one type of complex adaptive system.
The whole notion of complex systems is a new way of seeing the world, and it is not easily grasped. How exactly do agents in complex adaptive systems interact? How do they go about collectively creating, and then changing, a model for predicting the future? For those of us who are not scientists, finding a way to visualize the process is helpful. Brian Arthur gives us an answer with an example he dubbed “the El Farol Problem.”
El Farol, a bar in Santa Fe, New Mexico, used to feature Irish music on Thursday nights. Arthur, the Irishman, loved to go there. On most occasions, the bar patrons were well behaved, and it was enjoyable to sit and listen to the music. But on some nights, the bar was packed with so many people crammed together drinking and singing that the scene became unruly. Now Arthur was confronted with a problem: How could he decide which nights to go to El Farol and which nights to stay home? The chore of having to decide led him to formulate a mathematical theory he named the El Farol Problem. It has, he says, all the characteristics of a complex adaptive system.
Suppose, says Arthur, there are one hundred people in Santa Fe who are interested in going to El Farol to listen to Irish music, but none of them wants to go if the bar is going to be crowded. Now also suppose the bar published its weekly attendance for the past ten weeks. With this information, the music lovers will build models to predict how many people will show up next Thursday. Some may figure that it will be approximately the same number of people as last week. Others will take an average of the last few weeks. A few will attempt to correlate attendance data to the weather or to other activities for the same audience. There will be endless ways to build models to predict how many people will go to the bar.
Now let’s say that every lover of Irish music decides that the comfort level in the small bar is sixty people. All one hundred people will decide, using whatever predictor has been the most accurate over the last few weeks, when the limit is going to be reached. Because each person has a different predictor, on any given Thursday some people will turn up at El Farol and others will stay home because their model has predicted more than sixty people will be attending. The following day, El Farol publishes its attendance and the hundred music lovers will update their models and get ready for next week’s prediction.
The El Farol process can be termed an ecology of predictors, says Arthur. At any point, there is a group of models that are deemed “alive”—that is, they are useful predictors of how many people will attend the bar. Conversely, predictors that turn out to be inaccurate will slowly die off. Each week, new predictors, new models, new beliefs will compete for use by other music lovers.
We can quickly see how the El Farol process echoes the Darwinian idea of survival through natural selection and how logically it extends to economies and markets. In the markets, each agent’s predictive models compete for survival against the models of all other agents, and the feedback that is generated causes some models to be changed and others to disappear. It is a world, says Arthur, that is complex, adaptive, and evolutionary.
Brian Arthur is not the only Santa Fe scientist exploring the link between biology and economics. J. Doyne Farmer, originally trained as a physicist, knew that classical economics was based on the same equilibrium laws he had studied in college, but he also knew that what he observed in the markets did not always correspond with those laws.
Farmer was already convinced that the market was not efficient. That much was clear to him. Lawrence Summers, who was to become U.S. Treasury Secretary, was one of the original attendees at the 1987 conference on economics and complex systems. Summers researched the one hundred largest daily market moves and was able to connect newsworthy events to only 40 percent of them. In other words, more than half of the largest market movers were occurring without some corresponding informational input. This, Farmer knew, was highly inconsistent with the efficient market theory. It was clear that some internal dynamics were causing the excess volatility in the market. But what were those dynamics? Farmer, who possesses a natural sense of the curiosity that constantly pushes him into new arenas, thought that the answer might be found, not in the laws that explain celestial mechanics, but rather in the laws that describe the behavior of ecological systems.
Table 3.1
Biological Ecology | Financial Ecology |
Species | Trading strategy |
Individual organism | Trader |
Genotype (genetic constitution) | Functional representation of strategy |
Phenotype (observable appearance) | Actions of the strategy (buying, selling) |
Population | Capital |
External environment | Price and other informational inputs |
Selection | Capital allocation |
Mutation and recombination | Creation of new strategies |
In a Santa Fe Institute paper titled “Market Force, Ecology, and Evolution,” Farmer has taken the important first step in outlining the behavior of the stock market in biological terms. His analogy between a biological ecology of interacting species and a financial ecology of interacting strategies is summarized in the table shown here.14
Farmer is the first to admit the analogy is not perfect, but it does present a stimulating way in which to think about the market. Furthermore, it links the process to clearly defined science of how living systems behave and evolve.
If we go back through the history of the stock market and seek to identify the trading strategies that dominated the landscape, I believe there have been five major strategies, (which in Farmer’s analogy would be species).
1. In the 1930s and 1940s, the discount-to-hard-book value strategy, first proposed by Benjamin Graham and David Dodd in their classic 1934 textbook Security Analysis, was dominant.
2. After World War II the second major strategy that dominated finance was the dividend model. As the memories of the 1929 market crash faded and prosperity returned, investors were increasingly attracted to stocks that paid high dividends, and lower-paying bonds lost favor. So popular was the dividend strategy that by the 1950s, the yield on dividend-paying stocks dropped below the yield of bonds—a historical first.
3. By the 1960s, a third strategy appeared. Investors exchanged stocks paying high dividends for companies that were expected to grow their earnings at a high rate.
4. By the 1980s, a fourth strategy took over. Warren Buffett stressed the need to focus on companies with high “owner-earnings” or cash flows.
5. Today we can see that cash return on invested capital is emerging as the fifth new strategy.
Most of us easily recognize these well-known strategies, and we can readily accept the idea that each one gained favor by overtaking a previously dominant strategy and was then itself eventually overtaken by a new strategy. In a word, evolution took place in the stock market via economic selection.
How does economic selection occur? Remember that in Farmer’s analogy, a biological population is capital and natural selection occurs by capital allocation. This means capital varies in relation to the popularity of the strategy. If a strategy is successful, it attracts more capital and becomes the dominant strategy. When a new strategy that works is discovered, capital is reallocated—or, in biological terms, there is a change in population. As Farmer notes, “The long-term evolution of the market can be studied in terms of flows of money. Financial evolution is influenced by money in much the same way that biological evolution is influenced by food.”15
Why are financial strategies so diverse? The answer, Farmer believes, starts with the idea that basic strategies induce patterns of behavior. Agents rush in to exploit these obvious patterns, causing an ultimate side effect. As more agents begin using the same strategy, its profitability drops. The inefficiency becomes apparent, and the original strategy is washed out. But then new agents enter the picture with new ideas. They form new strategies of which any number may become profitable. Capital shifts and the new strategy explodes, which starts the evolutionary process again. It is the classic El Farol Problem described by Brian Arthur.
Will the market ever become efficient? If you accept the idea that evolution plays a role in financial markets the answer would have to be no. Each strategy that eliminates an inefficiency will soon be replaced in turn by a new strategy. The market will always maintain some level of diversity, and this we know is a principal cause of evolution.
What we are learning is that studying economic and financial systems is very similar to studying biological systems. The central concept for both is the notion of change, what biologists call evolution. The models we use to explain the evolution of financial strategies are mathematically similar to the equations biologists use to study populations of predator-prey systems, competing systems, or symbiotic systems.
The concept of evolution should not be foreign to financial analysts. Outside the markets, we can easily observe the multitude of systems that undergo change, from fashions to language to popular culture in all its manifestations. If understanding financial markets in terms of evolution seems intimidating to some, I suspect that may be because of the words biologists use to describe the process: Variation. Adaptation. Mutation. Genetic recombination. These are terms not found in the lexicon of an MBA program.
Perhaps it is easier if we switch to the vocabulary of the corporate world, where the concepts of managing change, encouraging innovation, and adapting to marketplace demands are well established and well understood. Simply put, the whole concept of adaptation is based on the idea that there is a problem, and the species—or the industry, or the company—eventually solves it by adapting to the environment.
The idea of biological economics should also be easier to embrace now that the theory has graduated from the Santa Fe Institute to mainstream universities and consulting firms that study business and management strategies. Richard Foster and Sarah Kaplan, from McKinsey & Company, wrote a very important book titled Creative Destruction: Why Companies That Are Built to Last Underperform the Market—and How to Successfully Transform Them. Clay Christensen, professor of business administration at Harvard University, has had a major impact on the curriculum with his best-selling books, The Innovator’s Dilemma: When New Technologies Cause Great Firms to Fail and The Innovator’s Solution: Creating and Sustaining Successful Growth (co-authored with Michael Raynor).
Andrew Lo, a finance professor at the Massachusetts Institute of Technology and director of the MIT Laboratory for Financial Engineering, has sought to strike a balance between two competing paradigms by suggesting the economic system actually possesses, simultaneously, the effects of both a Newtonian efficient market hypothesis and a Darwinian biological interpretation.
Remember that in the chapter on physics we postulated that although “equilibrium may indeed be the natural state of the world, and restoring it when it is disturbed may be nature’s goal, it is not the constant condition that Newtonian physics would suggest. At any given moment, both equilibrium and disequilibrium may be found in the market.” Andrew Lo’s The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective is heading in the same direction. Lo admits he struggled with the conflict between the two schools of thought for many years until it dawned on him that there was no conflict at all.
Lo reminds us of the well-known fable in which six blind priests come upon an elephant. The first priest feels the elephant’s leg and declares it to be a tree. The next priest feels the elephant’s side and claims it is a huge wall. Each priest touches a different part of the elephant and comes up with a different explanation. Andrew Lo sees the two different interpretations of the market in the same manner. “I realized that the behavioral finance folks and the efficient-market folks were both right,” he says. “They were both observing the same phenomenon, but from different angles.”
In Lo’s opinion, the market is neither exclusively efficient nor always behavioral—it is both. “Behavior is really the outcome of interactions between our logical faculties and our emotional responses,” he explains. “When logic and emotions are in proper balance, markets operate in a relatively efficient manner.”16 (We will look more closely at the tug-of-war between logic and emotion and its impact on investors in a later chapter.) Lo’s hypothesis seeks to bridge the gap between market efficiency and behavioral inefficiency by applying the principles of evolution, competition, adaptation, and natural selection to the financial interactions.
Many forward-thinking people, including several we have met in this chapter, believe that the theory of evolution may become the most powerful force in finance. “There are many opportunities for biological principles to be applied to financial interactions,” J. Doyne Farmer explains, “after all, financial institutions are uniquely human inventions that provide an adaptive advantage to our species. This is truly a new frontier whose exploration has just begun.”17
It is tempting, therefore, to rush full steam ahead toward a biological interpretation of the economy and the stock market. We can identify more analogies with biological systems than with physical systems. But we must guard our enthusiasm. This approach is still unfolding, and there are several missing pieces. One of them, according to Farmer, concerns the question of speed: innovation in financial markets is rapid, compared to the slow, random-variation process in biological systems. Because of this, Farmer believes the timeline for market efficiency may still be decades away.
There are some who are dismayed that evolutionary biology cannot make firm predictions. But Darwin never claimed that ability. The Darwinian revolution is very much about how change replaced stasis and, in doing so, gave us a more accurate picture of the behavior of all living things. In her book The Nature of Economies, Jane Jacobs captures the essence perfectly: “A living system makes itself up as it goes along.”18 For that reason alone, I believe that biological systems (stock markets included), unlike physical systems, will never possess a stable mean.
The German philosopher Immanuel Kant once said there would “never be a Newton of the grass blades.” He was wrong. The intellectual revolution caused by Darwin’s theory of natural selection is every bit as powerful as Newton’s gravitational force.
Indeed, the movement from the mechanical view of the world to the biological view of the world has been called the “second scientific revolution.” After three hundred years, the Newtonian world, the mechanized world operating in perfect equilibrium, is now the old science. The old science is about a universe of individual parts, rigid laws, and simple forces. The systems are linear: Change is proportional to the inputs. Small changes end in small results, and large changes make for large results. In the old science, the systems are predictable.
The new science is connected and entangled. In the new science, the system is nonlinear and unpredictable, with sudden and abrupt changes. Small changes can have large effects while large events may result in small changes. In nonlinear systems, the individual parts interact and exhibit feedback effects that may alter behavior. Complex adaptive systems must be studied as a whole, not in individual parts, because the behavior of the system is greater than the sum of the parts.
The old science was concerned with understanding the laws of being. The new science is concerned with the laws of becoming. How ironic it is that biologists, once thought to be the stepchildren of science, are now leading us away from the old science into the new.
It seems fair to give Charles Darwin the last word. He was a gifted writer whose scientific observations have become literary masterpieces. One of his best-known passages is the last paragraph in The Origin of Species, and it serves as a fitting end to this chapter.
It is interesting to contemplate an entangled bank, clothed with many plants of many kinds, with birds singing on the bushes, with various insects flitting about, and with worms crawling through the damp earth, and to reflect that these elaborately constructed forms, so different from each other, and dependent on each other in so complex a manner, have all been produced by laws acting around us. These laws, taken in the largest sense, being Growth with Reproduction; Inheritance which is almost implied by reproduction; Variability from the indirect and direct action of the external conditions of life, and from use and disuse; a Ratio of Increase so high as to lead to a Struggle for Life, and as a consequence to Natural Selection, entailing Divergence of Character and Extinction of less improved forms. Thus, from the war of nature, from famine and death, the most exalted object which we are capable of conceiving, namely, the production of higher animals, directly follows. There is grandeur in this view of life, with its several powers, having been originally breathed into a few forms or into one; and that, whilst this planet has gone cycling on according to the fixed law of gravity, from so simple a beginning endless forms most beautiful and most wonderful have been, and are being, evolved. (Charles Darwin, The Origin of Species)