Tuesday, July 07, 2009

Fear, Evolution, and the Genesis of Market Inefficiencies

It makes evolutionary sense that we are particularly hard-wired to learn from episodes of danger. An animal that tastes a poisonous food and becomes sick learns to avoid that food forever. That is known as single-trial learning (see this very relevant post on the topic); it occurs when the fear-based emotions associated with danger leave a cognitive and behavioral imprint. Once burned, the animal learns to be twice shy--or it does not survive.

I encourage readers to carefully study this post from Victor Niederhoffer. It is not by accident that he writes about food webs and "who eats who". The markets offer a tableau of evolutionary challenge no less than nature herself.

What to make of the finding that large moves up in the stock market are relatively equally accompanied by moves up and down in bonds, but large moves down in stocks tend to be accompanied by large up moves in bonds?

The dynamics of fear are quite different from those of euphoria. Nature ensures more rapid imprinting in the case of fear; survival trumps life enhancement in the scheme of evolutionary priorities. The large down moves in stocks are accompanied by flights to safety in bonds, but the large up moves in stocks don't necessarily lead to a flight from safety.

To the extent, however, that we can map moves in and out of particular asset classes as reflections of degrees of fear and safety, however, we can begin to appreciate where nature is leaving her imprinting. And that tells us something about market reactions that morph into market overreactions.

And that is one important way market inefficiencies develop. To ensure survival, nature invariably overshoots her mark.

More to come; hats off to Daily Speculations.