The Red Queen of Investing

The author is yet another high-quality writer from the Ritholtz stable and he has produced a really interesting piece of how trading, like other aspects of life, has gradually become an arms race. He begins by using Darwin’s theory of evolution to lay out the basic concept: “Darwin is in the Galápagos Islands when he notices something peculiar about the various finches living there.  Each finch species had a different kind of beak.  On some of the islands the beaks were small, while on others they were large.  Some were pointy and some were smooth.
As Darwin continued to observe the finches, he realized that their beaks were well suited for acquiring food on their particular island of residence.  It was as if the finches had adapted their beaks to fit their environment…Evolution by natural selection was born…However, by focusing solely on mother nature we miss half the story.  Because evolution isn’t just about adapting to the environment.  It’s also about adapting to the other players in that environment.  We don’t just evolve to face the elements, we also evolve to face each other.”
The author then highlights a book by Matt Ridley which expands on the point highlighted in bold font. “This is the critical point made by Matt Ridley in The Red Queen: Sex and the Evolution of Human Nature.  In the book, Ridley argues that there is an evolutionary arms race between predators and prey, parasites and hosts, and even males and females.  This ongoing conflict implies, as Ridley suggests, that “the struggle for existence never gets easier.”  As Ridley states in his book:
One of the peculiar features of history is that time always erodes advantage.  Every invention sooner or later leads to a counterinvention.  Every success contains the seeds of its overthrow.  Every hegemony comes to an end.  Evolutionary history is no different…The faster you run, the more the world moves with you and the less progress you make.  Life is a chess tournament in which if you win a game, you start the next game with the handicap of a missing pawn.”
The author then brings this analogy into the financial markets: “Just like the evolutionary arms race that Ridley describes, there is an investors arms race going on as well.  Once an investor finds an edge, it is only a matter of time until others figure out that edge and start copying it.  Long-Term Capital Management (LTCM) learned this lesson the hard way as explained by Sebastian Mallaby in More Money Than God:
‘Even though Long-Term shrouded itself in secrecy, routing its trades through multiple brokers so that none of them could understand its bets, an army of imitators had pierced together much of its strategy.  The upshot was that LTCM’s large portfolio was mirrored by an even larger superportfolio created by its disciples, meaning that LTCM’s trades were monstrously crowded.’
These mirrored trades were partially what led to LTCM’s demise when it couldn’t exit its positions without causing markets to tumble.  What had worked for LTCM for years suddenly stop working.”
So what implications does this theory for investors like you and me? The answer it would appear is: “…any complex, adaptive system like the stock market will continue to evolve based on the decisions made by its many participants.
This is why investing will never be easy.  Because if it was, then other investors would arbitrage any such easy return streams until it wasn’t easy anymore.  This explains why “buy the dip” will continue to work in this relentless bull market…until it doesn’t.  Or why gaining more information is advantageous until everyone else has that information as well.  Back and forth.  Back and forth…
To echo what my colleague Michael Batnick recently asked, “Why should you get reward with no risk?”
If the Red Queen has taught you anything, it should be that you (and your assets) will never be safe.  No advantage will persist forever….Because you have to earn your keep.  You have to be disciplined.  You have to work hard and keep working hard to hold onto your lead.  Because if it was handed to you, it will be taken back in time.  The Red Queen guarantees it.  So never stop running and make sure you earn it.”

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