What if evolution makes the New York Stock Exchange Tick?

Credit: Fransisco Diez / Flickr Creative Commons

Innovation Hub 1/26/13: The Biology of Stocks and Bonds

January 25, 2013

Guest:

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.

Boom and bust biology can help explain the fall of Lehman Brothers.
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Photo Credit: Arnoldius / Wikimedia Commons

Economic Evolution

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.


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