I am reading "Investing: The Last Liberal Art" by Robert Hagstrom (famous for writing "The Warren Buffett (Trades, Portfolio) Way," among others). The book is the second edition; the first one had another title, "A Latticework of Mental Models." While the current title is definitely more appealing, the latter makes a better description of the book's contents. What the book intends to do is describe, from the viewpoint of the main sciences, the core ideas and most powerful mental models in a practical way.
One of the most interesting viewpoints I have encountered is the one from biology and the concepts of adaptive systems and evolution. As a quick summary, the author emphasizes ideas from Darwin, among others, to describe the different investment strategies that have been dominant over the years. During the 1930s and 1940s, the discount-to-hard-book value strategy was in full swing. After WWII, the dividend model strategy dominated the markets. During the 1960s, companies experiencing high growth gathered the attention of the market. During the 1980s, the "owner earnings" model was widely implemented. Today cash return on invested capital is one of the preferred methods among investors.
As we can see, a strategy starts succeeding, attracts more investors until returns stabilize and the market seeks another investment strategy. Since this process follows the same process that nature follows, it captured the attention of different economists over the years. During 1987, at the Santa Fe Institute, a conference was held and among the attendees were Nobel Prize-winning economist Ken Arrow and Brian Arthur. The conference allowed this group to expand on the idea of complex adaptive systems that operate with multiple elements, such as the market. These systems are constantly evolving and generally have the following four characteristics:
- Dispersed interaction: The action of any one individual agent depends on the anticipated actions of a limited number of agents as well as the system they co-create.
- No global controller: The system is controlled by the competition and coordination between agents of the system.
- 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.
- 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.
According to this theory, the market will never be efficient. Why? It is simply because each strategy that eliminates an efficiency will soon be replaced in turn by a new strategy. The market will always maintain some level of diversity, which is a principal cause of evolution.
The market itself is a blueprint of human evolution. It is a complex adaptive system that provides a feedback loop, causing agents to form expectations based on models, which are retained or used as its efficiency is proved. I have always thought the permanent inefficiency in the market was caused in the inability we have as humans to separate our emotions from our thinking. While this could be true, the evolution standpoint definitely presents a strong argument against market efficiency also, at least in its perfect form.
What do you think?
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