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The dodo and investor survival
From the Financial Times of Fri, 19 Dec 2014 19:28:23 GMT

When trying to understand how the market is working, we should think not only of bulls and bears, but also of dodos. Our aversion to risk comes from the deep biological imperatives that have allowed humans to avoid extinction. Any theory of markets must take account of this.

That, at least, is the radical prognosis of Andrew Lo, of the MIT Sloan school of business, who has for years worked on an ambitious project to apply biology to finance. His latest paper, published with several colleagues, provides mathematical equations to show how risk-averse behaviour is necessary for survival. That means that investors in markets will take risk-averse actions rather than the purely rational decisions that economists have classically assumed.

“Risk-aversion is one of those behaviours that may not seem all that rational in terms of building wealth, or increasing the number of offspring,” he says. “But  . . . if you engage in more conservative behaviour, it’s much less likely that nature will eliminate you.”

If we are indeed hard-wired for risk-aversion in a mathematically clear-cut way, then we can explain why it is prevalent in many markets and we can incorporate this into models. But it is of more than academic interest.

It also shows that behaviour responds to changes in the environment, which is far more important than individual preferences. Dodos, for example, evolved in a comfortable island environment with no predators into large flightless birds who laid one egg at a time. Once their idyll ended, and humans and other predators arrived, they were extinct within a century.

Creatures that had adopted a more diversified strategy to reproduction could have avoided extinction. As Mr Lo puts it, “nature abhors an undiversified bet”. Surviving species, like humans, exhibit far more diverse and risk-averse behaviour than dodos. “When an environment is stable for a long time, we adapt to it. But if the environment shifts, that learnt behaviour can suddenly become very counterproductive.”

In the same way, external shocks to market environments cause long-running and deep-seated changes in investors’ behaviour. The theory explains why markets move in long secular phases. For an analogy, look at investor behaviour in 1999, a time that is under scrutiny as the US stock market approaches new highs under the guidance of a benevolent Federal Reserve. That came in an environment that had long been favourable to stocks, with gently falling bond yields and a strong economy, for almost two decades.

In the late 1990s, as now, the stock market suffered a succession of sharp corrections, usually driven by external events such as the 1997 Asia crisis, or the 1998 Russian default. Each time, investors treated the correction as a buying opportunity, and the market soon moved on to greater highs – until it finally reached unsustainable levels in early 2000, and crashed.

“Over that period, the only lesson that investors learnt was to buy on the dips, and over time that created a false sense of security. It lulled us into a period of low risk-aversion. “ says Mr Lo. The “wisdom of crowds” had been replaced by the “madness of mobs”.

After the crisis that behaviour shifted swiftly to great risk-aversion.

But what of the situation now? The similarities to the party of 1999 are growing uncomfortable. In the past two weeks, US stocks staged a dramatic about-turn as worries about growth, and a currency crisis in Russia, caused many to reassess their optimism.

Then, on Wednesday, Fed chairwoman Janet Yellen gave her quarterly press conference, and made clear that the US central bank would be “patient” in returning interest rates to normal. The result was a switchback. By mid-session on Friday, the S&P 500 was close to its all-time high once more, and the dollar was back at a new high for the year on a trade-weighted basis.

This looks suspiciously like learnt behaviour that has adapted to a benign environment. The Fed speaks in code, to keep its options open, but on this occasion it was perfectly possible to view Ms Yellen’s comments as a warning of higher rates to come. By saying only that rates would not be rising for the next “couple of meetings”, she alerted the market that rate rises could come as early as next April. It is plainly the Fed’s intention to raise rates next year unless conditions change. Even if it wants to nudge markets gently, to avoid the risk of another crash, that is the direction in which investors need to be nudged.

After years of monetary forbearance, it is not surprising that investors seized on the parts of her message that suggested the Fed would make their lives easy once again. That is the message they have learnt for almost two decade.

But that behaviour is worryingly reminiscent of the party of 1999 – and of the dodo.

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