From Static to Dynamic – The Nature of Investing: Resilient Investment Strategies through Biomimicry

Transformation 6

From Static to Dynamic

It had been a tough morning. Our firm held a stake of several hundred million dollars in one of the stocks I was recommending, and the company’s quarterly results had fallen short of expectations. The stock was down more than 10 percent, so we’d lost tens of millions of dollars.

The short-term disruptions at the company were well explained, and most were of a transitory nature: a slipped deadline here, some cost inflation there. Of course, every analyst wonders what she could have done to better anticipate problems like these, but I had analyzed the results carefully and was confident that prospects for the business were still strong. I was recommending that we not just hold the stock but buy more, which is what I conveyed to the manager of the biggest fund at my firm, the one who held the largest position in this stock.

He was not emotional or angry, despite the stock’s decline—quarterly results are always volatile, and we’d discussed this company together many times. Plus, every investor eventually learns how to calibrate his emotions, to try to distinguish between “noise” and more serious issues. At the end of our discussion he sighed a little and concluded, “Look, I understand the short-term issues, and I’m not selling the stock. But be careful when you make claims about long term prospects after a quarter like this. The long term is a series of short terms.”

Is it true? Is the long term really a series of short terms? Life’s principles of evolution show that it is that … and much more.

Nature’s Principle: Evolve to Survive

Timing on Wall Street is a tricky thing. Though many investors intend to be long-term in their orientation, we are constantly being pulled back to the day-to-day, minute-to-minute measurement that is now part of investment culture. One colleague of mine who dared to divest his Internet stocks in 1998, long before the dot-com bubble burst, was warned almost daily, “The market can stay irrational longer than you can remain solvent.”1 And indeed, every day that stocks like Webvan and eToys rose was like an eternity for my friend, both in terms of performance for his funds and in terms of the psychic toll that it took to watch those prices soar and soar.

During this same period, another colleague positioned his oversized market screens behind his desk, so he could work with his back to them for most of the day. I loved this idea and tried it eagerly, but I had to put the screens back in front within a few days because my back was so sore. I was spending all of my time twisting around in my chair, mesmerized by the flashing red and green numbers. Much as I thought my decisions were long term, my actions—at least in performance monitoring—were decidedly micro term.

Stretching to embrace the truly long-term view, as required by the natural principle, evolve to survive, can feel like an uphill battle for investors who are buffeted by short-termism. Yet when I think of the best investors I know, they have fully embraced this principle, always stretching to incorporate new ideas into their investment practice and always tacking toward the long term, even while immediate issues demand attention too. The long term is a series of short terms, yes, but simply pasting together short-term plans with no longer view will not produce a successful, resilient strategy.

The subprinciples of biomimicry’s principle of evolution are:

  • Replicate what works.
  • Integrate the unexpected.
  • Reshuffle information.

What are the components of a durable, evolutionary approach? Three factors come together within this principle to create a resilient strategy: first, replicate what works. This is a little like your grandparents’ motto, “If it ain’t broke, don’t fix it.” Think of a horseshoe crab—it looks like something that could have roamed around with the dinosaurs, in part because the crab has continued to replicate what works: the hard shell, the multiple eyes, the spiny “horn” for navigating. All of these features have existed (and persisted) for roughly 150 million years because they work.2

The flip side of replicating what works is the incorporation of new elements: integrate the unexpected. When the option for a new approach arises, it should be explored and, if successful, embodied in practice. An example here would be the snowshoe hare, which has giant back feet with claws that function like snowshoes—perfect for navigating across snowdrifted environments. When those feet first emerged, they were a mutation, one that happened to be especially well suited to the environment at hand. Another mutation allowed the hare to change color, so that it turns bright white in winter and brown-gray in spring, in order to blend in better with its surroundings. Over time the hares with these mutations fared better, and so the mutations gradually “stuck,” becoming integrated into the hare’s basic design. As habitats are now changing, some studies suggest that these mutations are a liability instead of a benefit, so it remains to be seen how the hares continue to attune in the short term, adapt in the medium term, and evolve in the long term.3

The key connector between replicating what works and integrating the unexpected is the ability to reshuffle information. Biologically, most of this reshuffling happens via reproduction, where all sorts of cross-pollinations and genetic variations are possible. The relationship between mammoths and elephants over time is a great illustration of information reshuffling; generations of the animal became less and less furry over time as their home climates became warmer and warmer.4

For human organizations and processes, these biological principles reflect three important concepts. First is the question of embodiment: for evolution to work, new ideas are not just ideas, they are fully incorporated into processes and systems. For many years I lauded the idea of keeping an investment diary, where you set aside time to note important events, your analysis, your emotion, and your decisions. And yet for most of those years, that’s all I did—I liked the idea. It wasn’t until I actually started keeping such a document that I could see patterns in my own biases and my own analytical tendencies. It was not thinking about this record keeping that helped, or recognizing that it was a good idea; it was the embodiment of this practice that finally led to positive impact.

The second important concept embedded in these principles is the definition of success. Natural measures of success are often easy to assess: if an organism survives, it’s successful. It’s tempting to translate this idea directly to our investment endeavors, to say that we have a “sink or swim” approach for new ideas or methodologies, but that’s a little too convenient, especially when our time frame for measurement is often very short. And in fact, to produce successful long-term evolution, we need to accept gigantic failure rates along the way. Most mutations are short lived because they provide no benefit, and indeed sometimes they hinder survival instead of helping it. So we need to identify “graceful failure” mechanisms in our endeavors, a way to try new ideas without putting too much weight on their early, risky outcomes.

For example, Peter Lynch, legendary manager of the Fidelity Magellan Fund, often referred to his “farm team” of hundreds of tiny holdings. These holdings were so small that any one of them could not have much impact on the portfolio, good or bad, but having them in the mix allowed these new ideas to be monitored, compared with bigger holdings, and generally “tried out.” If they were successful, they could grow to have real positive impact on the portfolio, but if they were unsuccessful, the price of failure was not too high. Though Lynch didn’t describe it this way, this practice is a great example of applying evolutionary principles to investing.5

However, employing this kind of evolutionary practice in investing is relatively rare, as it is eclipsed by fear. Jeremy Grantham, cofounder and chief investment strategist of Grantham Mayo van Otterloo, often notes that “The central truth of the investment business is that investment behavior is driven by career risk … you must never, ever be wrong on your own.”6 This very powerful, very human element of investing puts personal survival ahead of principled long-term thinking. In some ways, this is the most evolutionary approach of all: focus on survival. But focusing on short-term survival as an investor often has the unfortunate consequence of weakening the foundation for long-term survival. Defining success over an appropriate time frame, then, is a difficult and necessary piece of the puzzle.

Finally, the principles of “evolve to survive” weigh in very strongly on the notion of open versus closed systems. For many investment organizations, the allure of proprietary approaches looms large. Who wouldn’t want a proprietary trading system or a big stack of proprietary research to draw upon? But “evolve to survive” implies that we need to consider our esteem for exclusivity more carefully. For effective evolution, we need to ensure constant pollination of new ideas, and a system that is too closed off and buttoned up simply cannot provide enough of this newness. Even if a closed group can bring in lots of outside data and ideas, if there is no two-way flow, all it can offer in return is payment; there is no deeper exchange. For durable success, we need true exchange, not just paid data transfer. Though it is an uncomfortable shift, many investment organizations need to move from a proprietary, internally focused mind-set to a more open, innovative mind-set: from preservation to renewal.

Figure 6–1 Evolve to Survive: The Pollinators

The nectar in flowers evolved from ferns, and its sole purpose is to attract pollinators. Likewise, bees evolved to be optimal collectors—a 90mg bee can hold 40mg of nectar.

http://www.guardian.co.uk/environment/2011/apr/04/honeybees-entomb-hives

Translation to Investing

As noted above, it can be hard to consider finance and investing in a truly long-term, evolutionary context: sometimes even thinking beyond the next quarter feels like a curious, old-fashioned sort of thing to do. And yet timing is just as finely calibrated in nature: think of the mouse caught by a snake in just a fraction of a second or an apple tree that blooms just a few days too late for optimal pollination. Nature balances the short term and the long term just as successful investors do.

What is most essential in nature, as well as in investing, is adaptation and adjustment, across all time frames and all sorts of different environments. In fact, three of our six natural principles allude to adjusting, each with its own cadence. “Be locally attuned” is an immediate idea, focused on fitting in to the current environment at any given point in time. “Adapt to changing conditions” lengthens the time horizon to the medium term, explaining how best to thrive as the environment around us shifts. And “evolve to survive” is the longest duration of the three, concentrating on multigenerational change and survival.

Each of these principles references strategies for coping with changing circumstances, and each provides important road maps for investors as well. When it comes to evolution, the essential questions posed to investors are profound: What constitutes success? How can we manage the many small failures that are required in order to discover the factors that will lead to long-term survival? How can we incorporate new information not just on the surface but deep in the “DNA” of our processes? How can we create systems that are robust and unique yet still open enough to allow for true exchange?

Natural Scorecard: U.S. Dollar Evolution

Exchange is at the heart of long-term evolution, and there are many forms of exchange that are employed in investing: there are stock exchanges, of course, but also exchanges of information, exchanges of wealth, and more human exchanges as well—those of connection and collaboration. One form of exchange, the use of modern currency, is so ubiquitous that we rarely stop to consider it in depth.

There are fascinating and important debates to be had regarding the U.S. dollar: some argue for the return of the gold standard or some other measure of value that is linked to tangible assets. Others are intensely focused on monetary policy or on links between the dollar, deficits, and debt. These are essential questions, to be sure, but for the purposes of this analysis, we want to narrow our examination to a simple and specific consideration of the dollar in one of its primary roles: as a means of exchange.

Think of this one main function of the dollar, means of exchange, and how it has evolved over time. A condensed view of the history of exchange includes a progression that looks something like this:

  • Barter—direct exchange of services. “I’ll milk your cow if you feed my pig.”
  • Barter—direct exchange of goods. “I’ll trade you two pigs for your cow.”
  • Commodities as currency. “I’ll give you a peck of salt for your cow, and then you can trade the peck of salt with that other guy for two pigs.”
  • Coins as currency. “Thank goodness we don’t have to drag around kegs of salt anymore! Here’s a sack of gold coins as payment for your cow instead.”
  • Paper currency. “Even better! Here’s a promise of value in exchange for your cow.”

As this evolution took place, several clear advantages emerged: for one thing, more and more people were able to connect with one another. By the time we were using commodities as currency, the cow owner did not need to know the pig owner in order for them to trade. And just as importantly, we could carry around salt (or coins or paper) instead of pulling a cart full of pigs behind us as a means of exchange. So we could trade over longer distances and longer time frames, as well as between more and more people.

This evolution of scope also involved a transfer of trust. Instead of having direct trust in the quality of the pig or the honesty of the owner, with currency as the means of exchange we could agree on a value, trusting in that currency instead of the people or products at hand. Curiously, as money infiltrated many parts of the economy that previously relied on direct ties, this circulation of trust was not one-way. People began to evolve their use of money, linking money to specific sorts of trusted social relationships by using it for indirect transactions like housekeeping allowances, pin money, gift certificates, tips, and food stamps.7

More recently, we have moved from using paper to electrons as our currency. It might seem like forever since you had to physically go to a bank to withdraw money, but this electronic evolution has really occurred just in the last thirty years—the blink of an eye in evolutionary terms. As these electronic forms of finance have accelerated, trust in financial institutions has eroded: finance is the least trusted industry globally, according to the Edelman Trust Barometer.8 There are many plausible and obvious reasons for this erosion of trust in finance, of course, but part of the decline might have been enabled by our high trust in the dollar. When our trust in currency is high, perhaps our trust in institutions is somehow less essential.

Curiously, the latest evolution in currency, Bitcoin, includes a declaration of “non-trust” in its origin paper, declaring: “What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two parties to transact with one another without the need for a trusted third party.”9 This evolution of trust with respect to currencies is a vital piece of the puzzle: Do we need currency that eliminates trust, or do we need currency where our trust is more justified than it might be today?

Trust is usually considered a human-centric quality, but its equivalent exists throughout natural systems. Most of what we would consider trust in nature is a result of effective function and proven mutualisms, and that includes the evolution of function over the longer term. When we take the longer view, a wider range of questions appears and a wider range of assumptions is revealed. We think of the dollar as if it’s a static, permanent force, when in fact it has only existed in its current form for a couple of decades.

Given the rapid evolution of the dollar’s functions, it’s no wonder that lots of public attention is focused on those expanded functions and whether they are appropriate. Certainly, it is vital to question how and why we are using this particular economic organism in the ways that we are. But it’s just as vital to place all of those questions into a much longer-term evolutionary context. For now, let’s think about the central functions of the dollar, as a direct means of exchange and store of value, and how those functions hold up against the principles of effective evolution:

Does it replicate what works? Yes, the dollar builds upon the features of earlier exchange mechanisms and continues to perform their essential functions.

Does it integrate the unexpected? Pretty well—the dollar has taken on different and evolving roles, and has served as a means of exchange in different environments over time.

Does it reshuffle information? The dollar has taken in lots of inputs over time, from changes in policy to changes in other surrounding currencies. This is not quite a direct parallel to biological pollination and reproduction, but the dollar has interfaced with lots of other currency organisms over time and has evolved to maintain its overall function throughout.

On this basis, the dollar looks pretty sound (no pun intended)—a solid B grade. However, it’s not just a means of exchange anymore. How has the U.S. dollar evolved over the past century?

A quick survey of recent decades shows that we have evolved our use of the dollar to include all sorts of functions beyond being a (fairly) local means of exchange. Early on, function was extended to include acting as cross-border means of exchange and, more recently, as global means of exchange. Even more recently, the U.S. dollar has become a monetary policy tool, an international reserve currency, and a means of managing political as well as economic international relations.

Here is a brief summary of the extended functions of the U.S. dollar in recent decades:

• The dollar still serves its earlier function as a means of exchange, on a more and more extended basis.

• It also is used as a means of intervention, bought and sold by central banks and used as a tool in monetary policy; it was used in programs like the Marshall Plan and the Dodge Line to finance U.S. exports for rebuilding overseas after World War II.

• The dollar has increasingly been the default currency for global contracts, used as a means of invoicing, even for trade that has no other link to the United States.

• And it is used to determine exchange rates for other national currencies as well as many alternative currencies, making it a means of pegging value for these others.

• In addition to its role as a store of value, dollar-denominated assets are held by private agents, where the dollar is serving as a means of banking and holding reserves.10

Of crucial importance, as these extended functions were evolving for the dollar, its connection to other stores of value ended when the gold standard was eliminated in 1971. Since that time the dollar has performed broader and broader functions with a greater and greater reliance on trust. There is no longer a precious metal underpinning our currency’s value, which may prove vital when trust wanes.

Given the cross-purposes noted above, let’s examine this multifunctional view of the dollar’s alignment with “evolve to survive”:

Does it replicate what works? Well, we’ve continued to use the dollar as an effective means of exchange, and in fact this use has broadened. But we have taken up other mechanisms’ failures and put them all on the dollar, when we could have been evolving new and different tools instead. Ultimately, this overburdening may circle back to undermine the primary function of basic commerce as well.

Does it integrate the unexpected? When any mechanism is expected to fulfill disparate functions, it’s harder and harder to integrate the unexpected in one area without throwing others out of balance.

Does it reshuffle information? Since there is only one national currency in the United States (and increasingly concentrated use globally), there is very little chance for cross-pollination, for the introduction of new features from the outside. This is a serious systemic risk.

Though natural systems do exhibit multifunctional design, perhaps we have discovered the limits of multi-functionality when it comes to our many uses for the U.S. dollar. The dollar as default currency may have made sense when the United States accounted for most of the industrial production in the global trading world. However, now the U.S. is only about 20 percent of trading output, yet the dollar is still our major global currency. This is a mismatch that seems unlikely to persist.11 We have piled more and more requirements on this one form of currency, quashing opportunities for other forms and mechanisms to take on some of the functional burden.

Evolution: Local Currencies and Other Forms of Exchange

Though the dollar may be overburdened with our extended expectations, there are plenty of examples of alternate forms of exchange in the world. Lots of attention has been heaped on Bitcoin, but we are already using many forms of alternative, electronic currency without even thinking about it. That gift card from your grandma? Electronic currency. Airline miles? Electronic currency. Your frequent-drinker card that you swipe at the coffee shop? Electronic currency.12

One of the most interesting alternative currencies, though, is not enabled by the Internet or fancy cryptography: the WIR is over seventy-five years old. Launched in Zurich in the depths of the 1930s depression, the WIR is an organized bartering system—not for individuals, but for businesses.13 Value is pegged to the Swiss franc, but WIR francs are not convertible, so there is incentive for them to circulate within the system. The WIR system is a small portion of Switzerland’s economy, well under 1 percent of GDP, but it has been shown to provide disproportionate stabilization power, due to its countercyclicality.14 In short, when other financial groups are retrenching, the WIR bank tends to be more active.

The motto of the WIR founders strikes a notably different chord than the Bitcoin manifesto: “Free exchange of goods and services, without exploitation of our fellowmen, and without government coercion.”15 An independent, trust-based system.

There are robust local currencies across the world, from Brazil to the Berkshires.16 And, increasingly, there are other means of exchange for both goods and services, such as Freecycle and TaskRabbit. What is perhaps most encouraging is that newer technological platforms enable this sort of exchange on a scale that is both wide and deep. Businesses like Airbnb and Buzzcar allow the sharing economy to soar past the limits of physical proximity.

The rapid growth of these models has been enabled by several critical factors, notes Robin Chase, founder of Zipcar and now Buzzcar. First, there is tremendous excess capacity of stuff in certain circles, and tremendous need in others. Cars are one of the most obvious examples of this excess capacity, but power tools, spare bedrooms, and even free time all have similar capacity dynamics. Second, there is a network of peer collaborators: individuals who are active participants in the system, not just passive consumers. And third, there are technology platforms to facilitate all of the matchmaking, validation, and technical expertise that are needed. Skype, Wikipedia, YouTube: all of these models rely on easy-to-access platforms that enable excess capacity—from hardware to ideas—to be more effectively deployed.17

These new means of exchange embody evolution, incorporating change as it occurs. They allow room to incorporate small failures gracefully in order to improve the overall system. They are inherently open, transparent models, and trust is enabled through that transparency. In evolutionary terms, these developments are replicating what works while also integrating new features, functions, and capabilities.

Pathway to Practice

Our reliance on just one form of currency to fulfill so many functions has resulted in an inherently fragile, overburdened situation. Unless you happen to be the chair of the Federal Reserve, or maybe secretary of the Treasury, it’s unlikely that major decisions about the fate of the U.S. dollar lie in your hands. Still, this example gives us some helpful guidance on how to approach our own investing.

First, we can check to see whether our intentions are embodied ones or whether they are just that, good intentions. Do your investments “walk the walk”? Whether you are aiming for steady dividend income, tangible community benefit, or responsible consumer choices, it’s helpful to test our actions versus our hopes, even if we can’t always fully assess the outcomes.

Second, we can clarify our vision of success, adding creativity that goes beyond simple dollars or percentages. In evolutionary terms, success is usually defined as survival. What would success look like for your investing? A fancy new car? A college fund for your grandkids? A farm in your town that is saved from development? A longed-for trip taken or musical instrument mastered? How can we gently “mutate” and try new variations, recognizing that some won’t work out the way we hope? How can we help to perpetuate the ones that are successful?

Finally, we can be alert to whether the systems we engage with are open or closed. When I hear “open systems,” I often still hear a voice in my head that translates to “unsafe” or “not secure.” I have the urge to lock something. But an open system is just that—open. It allows for iteration, for inputs from the outside, for healthy rejuvenation and incorporation of new elements. I think of the long-term history of the United States as one of the greatest illustrations of an open system: our country has thrived in large part due to constant immigration of new people, new ideas, and new endeavors.

Sowing Seeds of Evolution in Your Own Investing

As I translate this evolutionary approach to my own investing, I ask myself, how might this investment change over time? Is it flexible enough to evolve on its own or will I have to be the one to do the adjusting? A thirty-year T-bill, for example, is a closed system; its design predetermines structure and duration. That’s great if it is a match for your needs, but investing with too much rigidity—whether in form, function, or philosophy—leaves us flat-footed when times change.

How can we think about long-term evolution for our investing?

Be clear on what constitutes success for our investments.

Be wary of overloading any one type of investing with too much function. Maybe all of our giving-related investing should not be writing checks to charities, for example. We can invest time. We can invest in responsible for-profit entities. We can invest in a more just world with our consumer dollars.

Allow for multiple “currencies”—different forms of investing, different reasons for investing, different organizations for investing. Different whats, whys, and hows.

Invest with pollination in mind. Pay attention to the openness of your investing over time. Closed systems appear to be consistent because they’re rigid, but that is often false comfort when conditions change.

As we employ the principles of healthy evolution, we can ensure our own survival.

We can foster pollination and evolution through open systems.

We can shift from static to dynamic.