Investing Lessons from Evolutionary Biology
This article first appeared in Founding Fuel
If you are reading this, chances are that you are an investor who invests in the stock market and mutual funds. If you are like me, your investing experience has been like a roller-coaster ride—periodic bouts of euphoria and depression interspersed with times when nothing happens.
I have been an entrepreneur for 20 years and an active investor for more than 15 years. I primarily invest in listed stocks and also do some startup investing. After having read many of the popular investing and business books, I have come to the conclusion that my best inspirations for investing are mostly from outside the field, e.g. from sports, literature and so on.
This piece is about one such source of investing learning: evolutionary biology.
Before moving on to evolution, let us contrast markets and nature. They are similar in many aspects.
1. Complex systems
Nature and markets are both complex systems. They often appear orderly and serene, but there are a million underlying factors that are operating underneath. These factors are simply too complex to even try to model or understand.
Events can always be explained post-facto but never pre-facto, hence it is foolish to spend time speculating on how the major events of the future shape up, like a rate hike or the direction of interest rates.
2. Regularity of cycles
The good and bad keep happening in both markets and nature with some regularity. In nature, all seems to be going well, until there is a sudden ice-age of a few hundred thousand years or a planet-wide dust storm.
Similarly in the markets, we see a regularity of boom and bust cycles. The presence of these cycles is a feature of these systems and not a bug.
More often than not, the very factors that build up and sustain a boom are creating the conditions for the ensuing fall (Soros calls this reflexivity). A great decade of easy housing credit in the 2000s led to the global financial crisis of 2008. To solve this crisis, global central banks ran a loose monetary policy for another decade which led to high asset prices and the resulting high inflation we have today. Inflation will have to be tamed, which will be done through monetary tightening, which, if overdone, could easily lead to a recession.
It’s like the circle of life. There is no getting away from bad news and down-turns.
3. Continuous nature of the game
Nature plays a continuous game, without any end. It has no love for the winners or remorse for entire species that perish. It’s just how the process is: mindless and continuous. There is no moment when a species is winning. The only difference is between being alive or dead.
Same with the markets. The markets are never in stasis. On every trade where we are buying with conviction, there is a seller selling that stock to us. If we buy a stock and sell it for double, it is no victory. We are now faced with a new problem of identifying another candidate to invest this money. And there is no guarantee that this new investment will be equally profitable.
There is no finish-line in the markets. The nature of the game is perpetual.
The gist of evolutionary theory
It was Charles Darwin who first came up with the theory of evolution. Evolutionary theory is the name given to all our scientific understanding of how life has evolved on our planet amidst adversities, how simple organisms have evolved into complex features, how parents pass traits to their offsprings, how a species branches into two new species, and so on.
In nature, organisms reproduce and have more offspring than can survive. The natural environment is harsh and the offsprings face a frequently recurring struggle for existence—e.g. food availability, predators, climate. Some of them will survive and go on to further reproduce. Others will perish (as most will) and meet a genetic dead end.
It appears as if the survivors have been selected by nature to move forward in the game, and hence this process is called Natural Selection or “survival of the fittest”.
Armed with the similarities between nature and markets, and our new-found concept of evolutionary theory, let us look more closely at how this area informs investing by way of rules.
Rule #1: Survival is the prime objective
The mighty dinosaurs roamed earth for over 100 million years. They were the largest animals on earth and the highest in the food chain. But something happened 66 million years back that caused them to go completely extinct. The exact nature of this catastrophic event is open for scientific debate. Biologists posit that there was an asteroid impact or volcanic eruption that led to this sudden extinction.
Jesse Livermore was a wall street trader in the early part of the 1900s. His bold trades made him so much money that at one time he was estimated to be the world’s richest person. His life story is captured in the famous book Reminiscences of a Stock Operator. Jesse lost all his millions in a sequence of bad trades. Surprisingly, he was able to recoup a large part of his wealth. By now, you would think he would have learned a lesson, but no. Jesse lost all his fortune again and shot himself in the head.
Survival is the first rule of the investing game. It is no use being very (paper) wealthy at some point if the wealth cannot be sustained in the near future. Nasim Taleb calls this robustness or antifragility.
For investors, robustness to negative events (black swans?) is achieved through asset allocation. The prudent investor must allocate capital in multiple assets: stocks, bonds, cash, property, etc.
During bull markets, when stocks are going through the roof, a diversified portfolio feels like a drag on returns. The investor is tempted to use the cash in the bank or sell the bonds to deploy into these hot stocks. But when the tide turns, as it invariably does, these conservative assets display their true survival value. (The ability to look relatively bad in bull markets is a necessary attribute of every investor.)
Rule #2: Trust compounding
All the wonderful features that we see in nature are by way of genetic “mutation” (change). Every time there is a reproduction, there is an infinitesimally small chance of a mutation, giving rise to some random new feature. Given vast time, these changes add up to create the wonders that we see around us.
The complex optics of our eyes and the aerodynamics of the wings of birds were not designed by some intelligent designer. They have grown incrementally from the countless small mutations and accidents over Very Long times.
The lesson is to trust small changes over a long time. We are almost sure to make good money in life by continuously investing small amounts of money every year for 40-50 years in a low-cost index ETF.
However, when we start investing, all of us are eager to get rich fast. And this compels us to take risks which may lead us to great wealth or ruin. I believe that this is because our minds are not wired to intuitively understand and trust the compounding process. To us, the forces that compound wealth appear very slow and boring and uninspiring.
Few people know that Warren Buffett was “only” a billionaire in 1990. Over the next decades, he kept investing in boring old-economy stocks (missing the tech boom completely). Today he is worth 100 billion just because of slow and certain compounding.
Rule #3: Avoid leverage
The cold war between the US and the Soviet Union led to a nuclear arms-race where both sides stockpiled weapons of mass destruction. Many times the world came close to a catastrophe, one instance being the Cuban missile crisis.
Looking at this from an abstracted evolutionary perspective, it seems as if an asteroid collision or climate change is not risky enough for us homo sapiens that we have to go ahead and build nuclear and biological weapons to hasten doomsday.
Similarly, regular investing is risky enough. But many investors make it riskier by borrowing money to invest, or dealing in derivatives that multiply exposure. When these leveraged bets do not work, it is game over for the investor.
The financial markets are full of firms and individuals imploding because of leverage and derivative positions. So much so that Warren Buffett termed derivatives as “weapons of mass destruction”.
The case of LTCM is folk-lore on Wall Street. Some fund managers joined hands with a couple of Nobel-prize winning professors to start a hedge fund in 1994. These professors had literally written the book on how to price derivative options (the famous “Black Scholes” option pricing model). Business was good for a few years. However, around 1998, there was a crisis in Asian and Russian currencies that went against them and caused them to blow-up. At the time of their bail-out, the firm’s net liabilities were calculated at $100 billion. (By the way, when asked what caused the problem, one of these professors commented that the currency crisis was a “one in a trillion event”!)
If Nobel-prize winners cannot be trusted with leverage, us mortals have no business even trying.
As average investors, we need to master the habits of saving and holding stocks for a long time. In the go-go years, there will be temptation from friends and TV pundits to get into quick rich schemes, borrow capital and trade derivatives. While it works, the investor appears a hero. But when the musical chair stops, the investor faces an ignominious exit from the game.
Rule #4: Be skeptical
Apart from explaining evolution by Natural Selection, Darwin also came up with the novel theory of Sexual Selection. This theory explained why males compete with each other for females’ attention (and why the peacock struts around with his colourful feathers). Later biologists added the concept of parental investment. This is the expenditure (in time, energy, food gathering, providing security) of each parent that goes into giving birth and rearing the offspring.
Obviously, the mother has a very high parental investment because of the requirement of incubating the offspring for a long time, rearing of the off-spring, and even a chance of death by mis-carriage.
However, this is not true of the male. In most species, the male is not monogamous and bears no responsibility beyond providing the genetic cocktail for conception.
The parallel in investing is that between advisors and investors. Third-parties like your broker, advisor, or wealth manager have no intrinsic skin in the game in the performance of your portfolio, like you do. They may mean well but their business is to offer their services to as many customers as possible and make a percentage of the AUM as fees. But for the individual investor, their money is hard-earned and they have much riding on it. (Economists call this conflict of interests as the principal-agent problem.)
The learning from evolutionary theory is for investors to be skeptical of every intermediary. The best way is to simply invest in index funds, direct mutual funds and stocks, while avoiding complex structures like the plague.
Rule #5: Let winners run
We saw that new features in organisms can only arise by mutations. These mutations are really the errors (infidelity) in the copying of cells, and are extremely rare events. Moreover, most mutations are extremely harmful to the organism. It is only one in a hundred mutations that is beneficial to its holder, increasing the chances of its survival and fertility.
A cornerstone of Darwin’s theory is that any such improved trait (adaptation) that enhances the survival and fertility of an individual will be inherited by its descendants and will be transmitted to a large fraction of the population in successive generations. (For those that are curious, it is through this gradual accumulation of adaptive variations over a billion years that species have evolved from their simpler ancestors.)
In investing, a portfolio will result in some winners and some losers after a few years. For most investors, the obvious thing to do is to sell these winners early, mostly under the pretext of taking out the initial investment, and letting the profits run. Peter Lynch calls this as “cutting the flowers and watering the weeds”.
However, the lesson from evolution is that once a winner is discovered, the sensible strategy is to let it run, even if it goes up manifold. The idea is to cut it the most slack. There are times when after going up a lot, the stock may do nothing for a couple years or even go down 50%. The only job of the investor is to track the business. If there is no significant deterioration or red flags, the investor must do nothing. Think of it as strategic lethargy.
If the investor must act, it is to add larger amounts of this stock whenever the opportunity presents itself: at lower prices during a market turmoil, or even at higher prices after great results.
This is how you get a 10x or 100x—by holding and adding onto a winner patiently for years and years.
Nowhere is this strategy more exemplified than in venture capital which invests in highly asymmetric outcomes. Every VC invests small amounts in many seed companies at an early stage. As and when a winner “emerges” from among this lot, the VC keeps investing larger and larger amounts (their “pro-rata rights” and more, or even from another dedicated “growth fund”) into this company, at higher and higher valuations.
Not all lessons from evolution are conservative.
Current state of the markets
As I write this piece, the US markets are in a turmoil, with investors having lost significant wealth in SaaS stocks. The crypto markets are going through their own crisis with the FTX implosion. (The Indian markets have held up this time—but won’t forever.)
The key understanding from evolutionary biology is that adverse events will regularly happen. The thoughtful investor is one who understands that investing is literally a life-long game and will not end in the next 10 or 20 years. Many bull markets and crashes will come along the way. In such a game, the objective is to survive and reasonably prosper, instead of trying to maximise gains and letting the next adversity whipsaw our portfolio and derail our plans for life.