David Weidner's Writing on the Wall
Dec. 11, 2012, 6:00 a.m. EST
The missing link of investing
Commentary: Science may explain why we trade
By
David Weidner, MarketWatch
Kevin Renes/Shutterstock.com
The evolution of a trader.
SAN FRANCISCO (MarketWatch) — When asked why we trade, many of us would answer with traditional, rational responses.
We see an undervalued company. We like a business, a brand or a strategy.
Or, it’s the flip side: We’re selling because we may think the fundamentals point to trouble. We see an investment that looks overvalued.
We even may understand that what underlies those explanations is the powerful and universal influence of fear and greed.
So it’s no surprise that most of us follow the herd. But what about the outliers? These are the people who stay calm when there’s a panic. They panic when there’s too much calm. They’re the contrarians. Sometimes their moves result in remarkable success. Other times, they get wiped out.
Recently, a subset of academic researchers have been studying trading decisions. Specifically researchers are looking into why some traders follow the crowd and others break away from the pack, sometimes destructively, sometimes with tremendous rewards.
It’s what the academics describe as a relatively new intersection of financial economics, psychology, and evolutionary biology including new interpretations of mutation. And the upshot, to me at least, is that we may not be as deliberative as we might think when it comes to trading decisions.
In other words, we’re wired to trade a certain way.
Andrew Lo, a professor at MIT Sloan School of Management and investigator at MIT’s Computer Science and Artificial Intelligence Lab, has been seeking to find out why so many bad decisions were made on Wall Street leading up to the financial crisis.
MIT, Northwestern
Andrew Lo (left) and Thomas Brennan say evolution may explain why we trade the way we do.
Lo, along with Thomas J. Brennan, a law professor at Northwestern, says the evolution of the human mind may explain a blind faith that housing values will rise and that mortgage securities and stocks would not fall in value as well as the opposite view.
In other words, many of us are bound to the pack. A minority of us break away from it.
Both behaviors are necessary from an evolutionary standpoint because they’re necessary for the species to survive. Every species needs its normal populations and its mutants.
The researchers argue that both behaviors — the pack mentality and the outliers — can be explained through evolution. Moreover, Lo and Brennan’s theory builds on the theory of “bounded rationality” proposed by Nobel-prize-winning economist Herbert Simon in the 1950s. Simon came up with the concept. Lo and Brennan believe they’ve defined the “boundaries” of bounded rationality.
Said Lo in an email, “when reproductive risk is the same for everyone in the population, the kind of behavior that confers the greatest survival benefits is not the selfish utility-maximizing behavior economists typically assume.”
The hedge, or mutant trade, “serves as a hedge against extinction,” Lo said.
Brennan added that the “hedge is valuable only when the entire population faces the same risk.”
In other words, nature has created these outliers to take the other side of the trade, according to the academics.
It’s clear that Brennan and Lo are onto something here. The idea of a greater intelligence at work in the markets isn’t new. Yet linking market behavior with the survival of the species from a Darwinistic perspective hasn’t been fully explored to my knowledge.
In a time when parts of the market are under scrutiny — the use of derivatives, futures, the role of short-sellers — this research may have practical benefits. If markets are evolutionary economics at work, then the need for risk takers is essential.
That’s because on a larger scale what Lo and Brennan seem to be suggesting is that there are natural laws at work. If that’s the case, then nothing should be too big to fail. No investor should be bailed out. And any type financial engineering from central banks to trading curbs may be muddying up the grand design.
Ultimately, when we buy or sell a stock, we may just be playing out a script crafted by nature over the centuries. And Warren Buffett may just be the right mutant at the right time.
