Perpetual Novelty, Santa Fe Style

Learnings from Science

By the late 1980's there was a growing recognition that the existing understanding of financial systems was flawed. Not only did markets not behave as the economic theories predicted but they often exhibited behaviour that didn't seem to have any pattern or cause at all.

In response to this a number of economists began looking at some of the research emerging from physics, biology and computer science in the area of complex adaptive systems and this led, in 1987, to a group of economists and scientists getting together at the Santa Fe Institute. The program of work that came out of this seminal event is still unfolding today, but suggests why academics and traders have had such different views on markets: one set lives in the real world, and the other doesn't.  Wanna hazard a guess as to which is which?

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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?

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Loss Aversion Affects Tiger Woods, Too

Behavioral Biases (3): Loss Aversion

Loss aversion, the tendency for people to be more risk adverse when protecting a gain than when chasing a loss, is a pervasive psychological bias. Indeed, it appears not even Tiger Woods is immune:

“Although the very best golfers are slightly less biased than their peers, even the best golfers—including Tiger Woods—exhibit loss aversion. This is a costly mistake. If any one of the top 20 golfers in 2008 was able to overcome this bias, his expected annual tournament earnings would have increased by $1.2 million dollars (a 22% increase).”

Put simply golfers play better when attempting to avoid dropping a shot than when trying to gain one, when they consistently leave their shots short. Yet this doesn’t make any sense – “bogey”/loss” and “birdie”/“gain” are purely relative concepts – all that should matter is the overall score or portfolio value.

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Capitalism Evolving: Be a Cockroach, Not a Dinosaur

Not Dying, Adapting

Many of the world’s most ardent free market economists would have us believe that the current wave of government intervention in markets heralds the end of capitalism. It’s not, because capitalism isn’t something you can kill, it simply adapts itself to the prevailing reality and carries on, regardless of economists and their ideas.

The proper metaphor for capitalism is evolution – which is ironic because Adam Smith’s invisible hand was one of the inspirations for Charles Darwin’s intellectual breakthrough, the theory of natural selection – a rare case of science imitating economics. Evolution, the process of life adapting to the complex changes in the natural world, is mimicked by capitalism, the process of markets adapting to complex changes in the financial world.

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