Fighting to Undo the Good Work We’ve Done

In an article named “Darwin for Investors”, there is an argument that there is no evolutionary stable strategy. The article shows how irrational and overconfident investors can misprice assets and do a lot of damage to economy. And here’s the kicker: they will do so for a long time before being driven out by rational investors. This is because, as the article explains, in good economic times, the evolutionarily stable strategy is to invest in risky assets. We assume that there will always be a decision between lower returns and lower risk versus higher returns with increased risk. Each investor must make a decision of where to invest. There are three kinds of investors: rational insider investors, rational outside investors, and irrational/overconfident investors. While inside rational investors will buy/sell at price points they know are correct, outsider investors have to rely on price data in the market. When irrational investors continue to invest into an asset rational investors don’t know whether it is a good bet or based on the perceptions of the irrational buyers. Natural selection then favors stupid money and works against rational, informed investors.

So when the economy does well, the payoffs change in the game, and subsequently the ESS changes to riskier investments. This isn’t only the case with obvious big bubbles, as the late Hyman Minsky said. Good times and economic stability are inherently self-destroying.

Natural will keep investing in risky assets as the evolutionarily stable strategy, until the house of cards falls. The mutant strategy of investing in safe assets will not be able to invade the strategy investing in risky assets in the time series where there are good times. 

Conversely, when the economy is not doing well the ESS will be to invest safely and limit speculation. The effect over time of this will be to grow the economy again. When the economy gains momentum, a similar problem arises where the ESS loops back to favoring risky investments. Thus, an ESS strategy in investing might be cyclical, not a static point.



Author: stevencosta

Temple University Junior, Beginner Wordpresser