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Robert Abbott
Articles (547)  | Author's Website |

Learning to Think Like Charlie: Biology and Evolution

The theory of evolution adds a powerful perspective on the stock market

July 08, 2019

Should the 1987 market crash have taken so many investors, economists and investment professionals by surprise?

In his book, “Investing: The Last Liberal Art,” Robert Hagstrom wrote, “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 30 years later, we learned this hard lesson all over again.”

It was what he called a “double failure of existing theory,” i.e., the equilibrium theory. That, he added, left the door open for a new perspective: biological. And more specifically, to a “big idea” from biology, evolution.

The concept of evolution is attributed mainly to Charles Darwin, who was born in England in 1809 into a family of scientists. His father, a physician, insisted that Charles follow his career path, but the young man refused. Then the father sent him off to Cambridge University to study divinity, and he earned a theology degree.

Cambridge also allowed him to an opportunity to pursue his real intellectual loves, botany and geology. Most importantly for our understanding of the world, he met a professor of botany who helped secure Darwin a position as the naturalist on a naval expedition. Its mission was to explore the coast of South America and eventually travel around the world. And the rest, as the old saying goes, is history.

The ship did not return for five years and by the time it got back, Darwin had a mountain of observations—and questions. The biggest question concerned what he called “the species problem.”

As he began to reach his conclusions, Darwin was torn between publishing his new theory and the shame that might arise because of its blasphemous nature. His hand was forced when Alfred Russel Wallace produced a summary of the theory that Darwin had been exploring. Under the guidance of two eminent and established scientists, the work of both Wallace and Darwin was published in a combined paper. The next 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 drew an inordinate amount of attention in the late 19th and early 20th centuries. And economists of the time took note, wondering if the concept of evolution might have relevance in their field. One of them was Alfred Marshall (who also helped integrate the idea of equilibrium into economics, as discussed in “Learning to Think Like Charlie: Physics & Equilibrium”).

Marshall was far from alone among economists. In 1928, Joseph Schumpeter published his first book, “The Nature and Essence of Economic Thought.” In it, he proposed that economics is essentially an evolutionary process. Schumpeter scholar Christopher Freeman wrote, “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.”

Hagstrom noted, “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 the Newtonian, or equilibrium, approach to economic change and development, change is thought to be slow and steady, or incremental. Schumpeter’s dynamic evolutionary approach, on the other hand, had room for “innovative leaps,” in which there were radical as well as incremental changes.

Schumpeter also may have influenced Marshall to some extent. In the preface to the eighth (and final) edition of “Principles of Economics,” Marshall wrote, “The Mecca of the economist lies in economic biology rather than in economic dynamics.”

Hagstrom next turned to Thomas Kuhn, author of the 1962 book, “The Structure of Scientific Revolutions” and the man who popularized the idea of scientific paradigms. He explained that puzzles normally are solved within the context of the dominant paradigm, but when anomalies occur and the dominant paradigm can’t solve them, a new and competing paradigm may emerge.

As with Darwin’s theory of evolution and Schumpeter’s creative destruction, Kuhn’s paradigm shifts can be highly disruptive, even revolutionary.

Economist J. Doyne Farmer, who had been educated as a physicist, was aware that classical economics was based on the equilibrium laws. But he knew real markets did not always work according to those laws. The market was not efficient. He thought the market might be better explained in the context of ecological systems.

Out of that thinking came Farmer’s paper “Market Force, Ecology, and Evolution”; Hagstrom argued, “Farmer has taken the important first step in outlining the behavior of the stock market in biological terms.” He added that Farmer concedes 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.”

Hagstrom used Farmer’s ideas to list five major strategies in financial markets history, an evolution so to speak:

  1. 1930s – 1940s: Discount-to-hard-book value, as originally proposed by Benjamin Graham and David Dodd in 1934’s “Security Analysis.”
  2. Post World War II: The dividend model, as stocks with high dividends replaced bonds in the portfolios of many investors.
  3. 1960s: Stocks with fast-growing earnings displaced stocks that paid high dividends.
  4. 1980s: Warren Buffett (Trades, Portfolio)’s strategy of buying companies with high cash flow or “owners-earnings.”
  5. 2010s: Emphasis on cash return on invested capital.

About that list, Hagstrom wrote, “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.”

What is economic selection? In terms of Farmer’s analogy, “a biological population is capital and natural selection occurs by capital allocation.” As a financial strategy becomes popular, it attracts capital and becomes the dominant strategy until it, too, is displaced by another strategy. In Farmer’s words, “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.”

Andrew Lo, author of “The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective,” sees no fundamental contradictions between the equilibrium approach and the evolutionary approach. He wrote, “I realized that the behavioral finance folks and the efficient-market folks were both right. They were both observing the same phenomenon, but from different angles.” Lo also saw this as the logical outcome of the tug of war between our logic and emotions.

In Hagstrom’s view, the old, Newtonian science concerns individual parts, rigid laws and simple forces, and the systems are linear, with the amount of change proportional to the inputs. The new evolutionary science is “connected and entangled, with sudden and abrupt changes. Small changes can have large effects while large events may result in small changes.”

His book, “Investing: The Last Liberal Art,” aimed to stimulate alternative thinking about the economy and markets. Inspired by Charlie Munger (Trades, Portfolio)’s “latticework of mental models,” the book so far has added two mental models so far: physics and the concept of equilibrium in markets, and second, biology, evolution and adaptive systems.

Hagstrom’s latticework of mental models is emerging, but not yet complete.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution." In his book, "Big Macs & Our Pensions: Who Gets McDonald's Profits?" he looks at the ownership of McDonald’s and what it means for middle-class retirement income.

Visit Robert Abbott's Website

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