Indexers use the efficient market hypothesis to help explain
generally why stock market averages are so hard to beat with
consistency. But efficient market theory does a poor job of
explaining bouts of speculation or panic - irrational investors.
One intriguing theoretical approach that incorporates irrationality
well is the evolutionary biology model. It requires no particular
level of rationality, efficiency or other assumptions that have
plagued the classical efficient market theory. A wealth of statistical
techniques support it, and it incorporates computerized analysis
easily.
"In the biological world species that do well are rewarded
by proliferating and those who don't die off," says J. Doyne
Farmer, McKinsey Research Professor at the Santa Fe Institute,
a complex systems think-tank. His seminal paper 'Frontiers
of Finance: Evolution and Efficient Markets' sums up this
approach.
As a twenty-four year old physics graduate student he was
a member of the "Dynamical Systems Collective" of UC Santa Cruz,
a group of pioneer nonlinear dynamics scholars featured in the
bestseller "Chaos" by James Gleick. He is also a successful
institutional trader of indexes for Wall St. through his firm
Prediction Company.
"A similarity in the investment world involves managers who
do well and increase their funds and managers who don't and
go out of business. It's quite clear that there is some strong
selection pressure in financial markets. Good investors are
selected and poor investors are weeded out. That is very different
than saying things are optimal. In biology there is little sense
of perfection."
The commonsense notion of relative efficiency works fine in
evolutionary competition. Species need not perform at optimal
levels to be successful. Humans, for instance, have chronically
bad backs but they still compete well as a species.
"Performance in markets is very much relative to players
in the market," he said. "The system is co-evolving. It is
dynamic. Efficiency doesn't happen instantaneously."
"It is clear from classic arguments that the market can't
be fully efficient. If it were, everybody would go home. There
has to be some kind of stasis where the market is pretty efficient
but not perfectly efficient. What does efficiency mean? What
are reasonable profits for taking risk that might involve
skill? Once you say the market is not perfectly efficient,
you need a way to talk about what that means."
What does this mean for the average investor? Inefficiencies
of boom and bust cycles are likely to exist, but it is hard
to say whether a successful investor is methodically exploiting
them or just lucky.
"My gut feeling is that there are substantial inefficiencies,"
he said. "Irrationality makes a difference. It s not just
that people don't have the information but that it's hard
to make reasonable inferences. I myself am often quite confused."
"Often managers who do well are very lucky. On average skill
is rewarded and those without skill die out. Track records
are indicative but it's important to know how to read the
fine print. Someone making a lot of bets probably has a more
meaningful track record than someone adjusting their portfolio
once a year."
And, yes, that is what he does on the side with Prediction
Company, a technical analysis firm he founded 9 years ago.
The company makes thousands of small trades each year for
money managers Warburg Dillon Read.
"It is clear from classic arguments that the market can't
be fully efficient. If it were, everybody would go home. There
has to be some kind of stasis where the market is pretty efficient
but not perfectly efficient." - J. Doyne Farmer