Markets, Evolution and Stable Strategies by Gaurang Bhatt, MD SignUp
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Markets, Evolution and Stable Strategies
by Gaurang Bhatt, MD Bookmark and Share
 


There are two basic theories of investments, fundamental and technical. Graham & Dodd's bible on value investing emphasizes that markets are irrational and periodically and cyclically overvalue and undervalue securities based on the cyclothymiac swings between greed and fear, the two major engines of human behavior. Warren Buffett follows value investing. Many earlier economic theories were based on the assumption that human economic decisions have a predominantly rational basis. The assumption of a 'Homo Economicus' have been overturned by the Nobel Prize winning work of Kahneman and Tversky, which showed that in volunteer experimental subjects there is a strong aversion to take losses and a predilection for choosing immediate rewards over delayed and extended rewards even though they may exceed in value the instant gratification. This is why investors cash in on small gains and hold on to their losing positions in the remote and futile hope of breaking even. This is one of the causes of resistance levels in stock prices.

Technicians believe that the current stock price reflects the current beliefs in the value of a given stock and the price movement reflects current proper valuations. Momentum players follow the trend and Newton's law of motion and jump in to buy overpriced securities, opposed by rational short sellers who have forgotten Lord Keynes' famous words that markets can remain exuberant longer than a rational short seller can remain solvent. This leads to a ballistic upward trajectory for some stocks until there are no more buyers and the exit doors are closing before a crash. The responsible factor is the human psyche. Supermarkets and department stores attract buyers by reducing prices for a sale. They then hope to make up for their loss leaders by jacking up prices on other essentials that the lured customer will need to buy or be tempted to buy. Stock markets do just the reverse. They raise prices to entice buyers who do not wish to lose a profit opportunity and jump on the moving train for a free ride. A look at the chart of the stock Rambus in 2006 will demonstrate what I mean. Disciplined and prudent investors make huge profits and the other kind are left holding the bag when the music stops.

The cynics follow a Gujarati couplet saying, 'Sansaari naa sukh avaa, jhaanjhwa naa nir jevaa', which translates that material pleasures are like the waters of a mirage, distant, ephemeral and beyond reach or grasp. Momentum players follow another Gujarati couplet, 'Maahi padyaa te mahaa sukh maane, dekhnaaraa daajhe re', meaning the fire of material pleasures is such that those within the fire feel ecstasy and bliss, while the outside observers get singed by jealousy. It is the psychology of behavior of crowds that momentum players depend on for their profits. Technicians and their tomes assist in making the momentum driven directional motion a self. fulfilling prophecy. Crowd behavior can turn on a dime and be very fickle. Interested readers may wish to read about the bankruptcy of the hedge fund LTCM in Roger Lowenstein's book 'When Genius Failed' about quants and Nobel Prize winning economists.

Evolution provides numerous examples of population swings and what George Williams and W. D. Hamilton defined as evolutionary stable strategies. Canadian lynx (predators) and hares (prey) cycle as each population grows and crashes in an inverse relationship. Variations in the genes of a given population makes them less susceptible to a single pathogenic parasite. The planting of US soybean and corn crops of a single genetic variant led to the devastation of the majority of crops by parasites in the seventies.

One reason why wasteful sexual reproduction was invented by evolution is to battle parasites. A self-replicating hermaphrodite or a parthenogenetic lizard does not have to waste time and energy finding a date on Saturday night. The problem is that all offspring will have identical genetic composition as the parent. It is like buying one hundred tickets with identical numbers for a lottery. It does not increase the chances of winning. Sexual reproduction by permutation and combination gives hundred lottery tickets each with different numbers. Inbreeding with the same HLA ( histo-incompatibility) antigens makes the entire population identical locks, susceptible to those pathogens with the right molecular key, as the American Indians found out due to the malignant charity of the Spanish Conquistador Catholics and Protestant British Pilgrims, who gave them smallpox infested blankets. Karl Sigmund's book 'Games of Life' spells out the details.

Any of you who watched the PBS program Nature on figs and wasps must have seen that there is a symbiotic relationship between fig trees and fig wasps. The female fig wasps pollinate the fig and lay their eggs in it, thus propagating both species. The program showed other wasps species with a drilling ovipositor that lay their egg on the egg of the fig wasp. The drilling freeloader wasp's larva uses the fig wasp's egg as its meal ticket. The freeloader's egg develops into a female or male. All females are winged. Males come in two varieties, winged or wingless. The wingless males do not even look like wasps and are vicious, with big jaws that they use to kill any other males they meet within the fig. They are obsessed with sex and mate with every female they meet within their fig, where they are born and will die. Thus there is no chance that any female in their fig (destined to fly away because of her wings) will emerge unmated. 

Why then are some males born winged? There will be some fig in which the mother may have laid only one female egg or all female eggs. These females will emerge unmated from the fig and the emerging winged males from another fig successfully mate with the unmated females. Hamilton calculated that if the number of male eggs in a single fig is greater than three, the winged males have no mating future to speak off, as all the females in that fig will have mated with one or more promiscuous wingless male. If the average number of male eggs per fig is one or less, the wingless males have no future. They will die unmated in their natal fig. Those parasitic wasps with the frequency of male eggs per fig of two have the two different types of male progeny with approximately 80% wingless. He studied the matter further and found the evolutionary stable strategy which actually occurs was that the percentage of winged males for a given species was in good agreement with the percentage of females that left their natal fig unmated for the same species. This does not mean that the percentages are fixed. They oscillate and tend to return to the stable state, to fluctuate once again. Just as in immune defenses against common parasites, the rare and uncommon survive and flourish, so also the rarer variety of males in greater demand increase at the cost of the commoner variety. By becoming more common they lose the advantage and recede in numbers. Thus success lays the seeds of failure as in the case of empires.

Stock markets oscillate similarly. When everybody is bullish, the market tops out and when everybody is bearish, the market bottoms out. Another strategy used by savvy investors is the contrarian one. Sell when everyone is buying and buy when there is blood in the streets. There is an apocryphal story that Rockefeller sold out prior to the 1929 market crash because his shoeshine boy started giving him stock tips. The Indian market had a similar situation where betel-nut sellers were giving stock tips prior to the Harshad Mehta crash. These cyclical swings in markets and the relevant formulas of Game Theory are equally useful in interpersonal relationships (Prisoner's Dilemma), War and Nuclear Deterrence Strategies (MAD) and Security Bid Auctions (Nash Equilibrium). Interested readers may wish to read Richard Dawkins' book "Climbing Mount Improbable" for the biology of figs and wasps.   

3-Feb-2007
More by :  Gaurang Bhatt, MD
 
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