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Genetics & Brokers: Why We Are Horrible at Predicting the Stock Market

There are few things more dramatic than brokers with hands on their faces – the pain, the agony, the defeat, it’s all there. Whenever I see pictures like the one above, I wonder what could have possibly gone so wrong. Turns out that a whole bunch of things could have gone wrong, and losing a lot of money in a small amount of time is at the top of the list.

The question is: Why are people so bad at predicting the stock market?

The answer could rest in evolutionary biology; we are poor predictors because natural selection did not favor individuals who thought about specific long-term events – it simply wasn’t advantageous for someone to understand something as abstract and elaborate as the future of stock market prices. Nassim Taleb makes this point nicely:

Our minds do not seem made to think and introspect; if they were, things would be easier for us today, but then we would not be here today and I would not have been here to talk about it – my counterfactual, introspective, and hard-thinking ancestor would have been eaten by a lion while his nonthinking but faster-reacting cousin would have run for cover… our predecessors spent more than a hundred million years as nonthinking mammals and that in the blip in our history during which we have used our brain we have used it on subjects too peripheral to matter.

Here’s the key. The genes of our primitive hunter-gathers ancestors “were, for all practical purposes, the same as ours.” This means that the size and make-up of our brains have remained largely unchanged since they evolved for the hunger-gather life style roughly 100,000 to 200,000 years ago. So when it comes to something like the stock market, our predictive power sucks because our genetics just aren’t up for the task. Our brains were built for existing in the moment and making quick useful decisions on the African savanna, not for simulating future stock prices in Manhattan, in other words.

How, then, do you explain the Warren Buffets of the world? Simple. If you take a million pennies and flip each of them ten times a handful will land on heads or tails ten times in a row; if you have a thousand pundits predicting the outcome of an event it is highly likely that at least a few will get it correct; and if you have 7 billion people participating in a global economy there will always be a handful that make a lot of money. In short, he benefitted from chance.

But not everyone agrees. In the 2009 book The 10,000 Year Explosion, Gregory Cochran and Henry Harpending argue that the development of agriculture nearly 10,000 years ago accelerated the rate of physical, biochemical, and cognitive evolution which caused our genetics to differ significantly from hunter-gathers. In addition, a wave of new books such as David Shenk’s The Genius in All of Us, Daniel Coyle’s The Talent Code, and Malcolm Gladwell’s Outliers, highlight our poor understanding of the role of genetics in physical and intellectual ability. Taken together, these two points challenge the notion that our genetics have not significantly changed since hunter-gatherer days. So maybe Warren Buffet was smart after all.

As for the stock brokers with hands on their faces, well, maybe they are just bad stock brokers.

3 Comments Post a comment
  1. George #

    What I am struck by in financial markets is overreaction. Last week with the downgrade to AA+ ratings on US Treasuries, a fire sale ensued. This could have been the private sector’s frustration with the public sector’s inability to act constructively and efficiently manifesting itself but it seems to me to be excessive. Last year after the BP oil spill, prices dropped below $27 / share; today they are selling for about $40/share. Somebody buying at market bottom would have gained a 48% return, that level of return should not happen in competitive markets in such time but because of short term overreaction, it exists. I understand I have not touched on the context in which this occurred and its not like many people had extra money to invest in a wounded business over the past years but there are many examples of excessive actions in the short term that have significant ripple effects throughout the economy that, to me, seemingly could have been avoided with more prudence.

    August 12, 2011
    • George #

      I forgot to add to the context that there is also some environmental morality involved. However, I don’t think those trading for a living are as concerned with that.

      August 12, 2011
      • sammcnerney #

        “That level of return should not happen in competitive markets in such time but because of short term overreaction, it exists.”

        There is nothing normative about the stock market. Shit just happens

        August 12, 2011

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