The Hindu Business Line : Evolutionary finance

A biology professor I know is a fairly successful equity trader. He does not borrow any strategy from his biology textbook, but insists that there is some relationship between evolution and the capital market. He is correct. There has been extensive research in the area of evolutionary finance, a study that links biology and finance. Evolutionary finance borrows heavily from Charles Darwin's Theory of Evolution. It studies trading strategies and not individual investor behaviour. This is similar to Darwin's view that species and not individuals are important for evolution.

Assume that a forest contains rabbits and foxes. Evolutionary biologists are not bothered about whether a particular fox eats a particular rabbit. Rather, how foxes compete against rabbits. Similarly, researchers in evolutionary finance are not bothered if a particular fund follows a small-cap growth strategy. What matters is how much wealth chases each strategy.

That's not all. There is a parallel in the capital market to biology's natural selection! Market selection refers to the way professional managers and investors select their trading strategies.Finally, the most important factor in evolution is mutation, which refers to changes in genes. In the stock market, this refers to the changes in the market dynamics. In evolution, as Darwin argued, there are two forces at work — one that reduces the variety of species and the other that increases it. So it is in stock market.

The market dynamics are governed by strategies. If a strategy has gained wealth, then some other strategies must have lost equal amount of wealth.

(The author is Head, Research, Navia Markets.)

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