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Fri January 25, 2013
Innovation Hub 1/26/13: The Biology of Stocks and Bonds
- Andrew Lo, professor of finance and Director of the Laboratory for Financial Engineering at MIT's Sloan School.
The stock market may be tough to predict. Even marquee investment houses build wrong guesses into their business models. But here's what's not tough to predict: humans trading stocks and making investment decisions will make mistakes — sometimes with tragic consequences.
MIT's Andrew Lo argues evolutionary biology may be the key to understanding how humans react to financial choices, and how they may behave in the future.
What could the theory of evolution possibly have to do with Wall Street? Lo starts with one of Darwin’s famous maxims: the survival of the fittest. In nature, the process of natural selection predicts that weaker organisms will die before they procreate, ensuring that their inferior genes don’t get passed on to the next generation. But on Wall Street natural selection means something a little different.
“When you look across the trading floor, you notice that there are very few old traders,” Lo says. “The process of trading is an emotionally and physically taxing kind of a profession. Right there, you see a little bit of evolution before your very eyes. The fact is you don’t have very old individuals involved in trading, because it’s just not the kind of thing [someone can do] over years and years.”
And evolutionary biology can do more than just explain what we see on the trading floor. Lo argues it can help us understand the success — and subsequent failure — of banking giants like Lehman Brothers, which declared bankruptcy in 2008.
“Part of the problem is that success breeds additional growth, as all evolutionary processes will [show],” Lo explains. “So over the years, as Lehman became more successful, they ended up engaging in larger and broader businesses, and, ultimately, it got to the point where the businesses that it found itself in could not easily be unwound over a short period of time.”
Lo argues that it was Lehman’s rapid success and sustained growth — the firm’s compound rate of return to shareholders was 22 percent for the 12 years after it went public — which led to its ultimate demise. That’s due to an evolutionary theory called “boom and bust.” If a population finds a hospitable environment, it will grow quickly. But when it depletes the resources of that environment, the population will crash just as quickly.
“Part of the evolutionary process is growing and then ultimately failing if you can’t sustain that growth,” Lo explains.
Fighting Your Instincts
So what happens when humans make decisions that are evolutionarily sound but don’t make sense for their stock portfolios? Lo says the first step is to understand that natural selection is at work in financial markets. The second step is to act, rather than react.
“Very often, people look at their portfolios only when it’s necessary; only when there’s a big market movement up or down,” Lo says. “The fact is that you need to think about your portfolio on a much more frequent and much more systematic basis.”
Lo notes that decisions made in a crisis usually lead to bad outcomes — so it’s best to work out a plan for your financial goals before the next big economic swing. Luckily, he says, while the market might feel uncertain, we can predict its unpredictability.
“We know that there are going to be market crashes. We know that there are going to be market booms,” he explains. “So if we can understand exactly what our financial objectives are — if we can plan for those kinds of events, and at least go through a fire drill in our head of how we are going to behave in those circumstances — we might actually be able to make a better decision, as opposed to deciding in the spur of the moment.”
If you remember one thing when developing your own investment strategy, Lo hopes it’s thinking deliberately about your choices in advance, rather than just following the crowd. Ask yourself how much loss you can sustain — and what you would do if the market dipped 10 percent tomorrow.
“Following the market, following the crowd, can be dangerous if you don’t know where the crowd is going or why it’s going there,” Lo says. “Just look at lemmings — you probably wouldn’t want to follow them very long.”
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