Financial systems and processes are becoming what nuclear physicists often call tightly coupled systems. What does this mean? When a system is tightly coupled, it means that many complex processes are finely integrated with each step needing to be efficient and optimized. A good example of a complex system is a nuclear power plant. The problem with nuclear power plants is that they are complex coupled systems and occasionally in history experience meltdown. Like nuclear power plants, financial systems have become more complex and tightly coupled leaving them prone to experience financial meltdowns. This is because hidden in tightly coupled, highly optimized complex systems lurks fragility.
Biological systems are built to adapt to stress. This is a product of evolution. Natural selection removes the systems and processes prone to meltdown. Nature has a way of building for survival in the long run. Biological systems adapt and evolve over time and they seem to be built to avoid some of the fragility of complex systems. The opposite of fragility is antifragility. Antifragile things gain from disorder. They like volatility and stress and they tend to thrive under seemingly difficult situations – a concept highlighted by Nassim Taleb in his latest book, "Antifragility: Things that gain from disorder". In his book, he uses the example of human bones where, given moderate levels of stress, our bones become stronger yet with no stress they deteriorate or with excessive stress they break.
What can we learn from evolutionary biology?
In a world full of investors who have studied the efficient market hypothesis, how can we make sense of the current state and recent financial meltdowns? Truthfully, given our traditional efficient markets perspective this doesn’t make much sense at all. In fact in 2004, Professor Andrew Lo from MIT proposed a new view on markets which he dubbed the adaptive markets hypothesis. Professor Lo suggested that finance might learn a few lessons from evolutionary biology. The adaptive markets hypothesis takes the view that markets are like ecologies. These ecologies are made up of the members or participants. An ecology changes dynamically as a function of environmental factors, the composition of participants in the ecology, competition, and abundance of resources. In a financial setting, the market ecology is made up of the market participants each its own species of sort. Market participants are pension funds, hedge fund managers, retail investors, etc. The financial market environment depends on the environmental factors (regulation, sentiment, etc.), the composition of active market participants, the level of competition, and the amount of reward that is on the table.
Prices are determined as a function of the current market environment and the number and distribution across the financial species active in the market. Opportunities exist when resources are present and competition is low. As competition increases, the forces of natural selection will allow those able to adapt and compete to outperform other market participants. The demise of less adaptive market species will reduce the competition allowing for the cycle to start all over again. The waxing and waning of hedge fund styles over time provides a good example of adaptive markets and the role of competition. In fact, there are many other examples which are consistent with this theory.1
How can we view antifragility in adaptive markets?
When competition increases we try to find ways to make our systems more efficient. As we make these systems more efficient we tend to optimize them making them more complex and set to fit to current market conditions. Using portfolio management as an example, these days where opportunities seem far and few between we tend to try to over optimize our systems desperately trying to squeeze out risk premia wherever we can find them. If we take an adaptive markets view, when the market environment changes, success is contingent on either luck or the ability to adapt. It is precisely the antifragile which may be able to adapt. The antifragile thrive in moments of stress and disorder. If we turn to more practical interpretations of an adaptive market’s view, we can take a closer look at the past few turbulent years in financial markets in a new perspective. The financial crisis exposed hidden risks in our tightly coupled and complex financial system. When these risks and weaknesses were exposed, the market environment changed drastically in a spectacular meltdown that left many financial species extinct or on the brink of extinction. Few players waved the storm well. Some got lucky sitting in the right place at the right time (the Paulsons and the short equity traders of the world), the few that were antifragile profited, and the remainder of market players suffered substantially.
Two simple examples of strategies that could be deemed antifragile during this moment are systematic trend followers and Warren Buffet. Both profited lavishly from this unfortunate scenario. Perhaps a closer look at why they seemed antifragile as opposed to lucky may provide some clues into what types of strategies are more antifragile. The key to their success is being conservative, patient, and opportunistic. First, Buffet is conservative in the way he allocates his funds remaining liquid by maintaining cash for a rainy day. His approach is patient and when there is an opportunity, as there was in a post crisis mess he takes the opportunity to invest in the undervalued – being one of the few able to do so. Systematic trend followers endure risk controlled volatility in markets day in and day out. They control their exposure in risk and they remain liquid allowing them to adapt. They patiently endure market volatility over time, waiting until the right market moves occur. When there is an opportunity, they are ready and able to take advantage of it. A closer look at those who seem to be able to be antifragile, seems to suggest that the combination of safe (conservative and patient) with opportunistic allows an investor to be more successful over the long run.2
The quest for antifragility?
The question any investor must ask themselves is will they just rely on luck or should they consider finding ways to become more antifragile. The classic approach to remain somewhat antifragile is diversification. In the current market environment, diversification is not sufficient. Going back to our market ecology view, if every market participant is doing similar things there is no ability to adapt to a stress situation. Put more simply if no one diversifies except you, diversification will protect you. If everyone diversifies the same way as you, you are simply one of the herd making you fragile to the weaknesses of the herd. To become more antifragile, you must consider adding some volatility to your process. Just like moderate stress and challenges are good for your health, some variation and open-mindedness is good for your portfolio. The following three suggestions can help a portfolio manager to access their investment approach.
The future of financial markets remains unclear; uncertainty plays a greater role in life than calculated risk. By taking an adaptive markets view, it is important to understand how we, as market participants, play a role in the modern financial ecology. In order to design sustainable systems and build sustainable investment portfolios, we need to consider strategies and structures similar to biological systems which are highly adaptive, complex yet antifragile. It seems one of the only ways to overcome uncertainty may be to embrace antifragility.
References Lo, A.W., Adaptive Markets and the New World Order, Financial Analysts Journal, Vol.68 (2012), pp.18–29. Lo, A.W., Survival of the Richest, Harvard Business Review, March 2006. Lo, A.W., The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective, Journal of Portfolio Management Vol.30 (2004), pp.15–29. Taleb, N., Antifragility: Things that gain from disorder, Random House, New York, 2012. Footnotes
1 For more information on this topic, Andrew Lo gave a sequence of several lectures on the Adaptive Markets Hypothesis at Oxford. See http://www.argentumlux.org/presentations-40.html 2Taleb discusses the barbell heuristic in his book. A simple example of a barbell strategy is 80% safe assets with 20% convex assets. The 80% is conservative and the 20% opportunistic. Practically this portfolio includes an investment in things which are safe like cash, Tbills, and even things you need to consume (some might even consider fine wine as an example) while the convex portion should include “long volatility” investments that have a huge payout in rare extreme scenarios. There are many examples of barbell heuristics in practice especially outside of finance. In fact, one can even argue the new popularized fasting diet the 5:2 diet is based on the same principle.
(Thought leadership article for "Institutional Insights" / Eurex Group)