Asset management, Behavioral finance, Commodity risk, Complexity, Hedging, Market psychology, Market research, Market trends, Psychology, Risk management, Something completely different, trading, trend following, Uncategorized

Speculation in the natural world

Nature has … some sort of arithmetical-geometrical coordinate system, because nature has all kinds of models. What we experience of nature is in models, and all of nature’s models are so beautiful. – R. Buckminster Fuller

Nature’s survival strategies that bear the most similarities to activities of market speculators are those of predators. To live, predators must hunt and this activity includes elements of speculation. Like trading, predation requires knowledge, skills, judgment and decision-making. It also entails risk and uncertainty. A predator can’t be sure where her next meal is coming from. Each hunt is an investment of resources; it involves the risk of injury and loss of energy expended in failed hunts, which tend to be more frequent than successful ones. To survive and procreate, predators must consistently generate a positive return on this investment. Too much of a losing streak could turn out to be fatal. In his book, “The Serengeti Lion: A Study of Predator-Prey Relations” George B. Schaller painstakingly documented the details of hundreds of hunts by large cats in the Serengeti National Park in Tanzania. We have all seen wildlife television programs showing lions and cheetahs hunting, but Schaller’s work offers a much richer account of the life of predatory cats including their hunting behavior.

The anatomy of a hunt

Lions prefer to hunt at night, especially when the moon is not bright. Because most of the animals they hunt can easily outrun them, lions must take every advantage of external factors like darkness, dense vegetation or the vicinity of water. While hunting, they rely on sight, hearing, and smell in the order of decreasing importance. Lions see much potential prey in the course of a day and evaluate the likelihood of catching any that appear vulnerable. “Most are given a glance,” writes Schaller, “some merit a closer look, a few elicit hunting movements, and only a very few are actually pursued.”

Lions use several distinct methods of hunting, which include ambushes, drives, runs and stalks. On occasion, lions make unexpected kills when a sick or injured animal stumbles upon them. The most common strategy is stalking, where lions attempt to approach their prey undetected. To conserve energy, lions are extremely selective about engaging in the actual chase and generally don’t charge unless they’ve been able to approach their prey undetected to within about 30 meters or less. The decision to attack also depends on the lion’s judgment of her own fitness as well as that of the prey: chases after young animals are generally longer than those in pursuit of adults. If a chase is failing, the lion is quick to abandon the attempt and only seldom pursues the prey for more than 200 meters.

The risk of injury is another important concern. To avoid violent impact, prey is almost never attacked from the front, and when making a kill, a lion is careful to position her body where its victim’s horns or thrashing hooves cannot reach her. Still, accidents do happen and Schaller reports seeing lions with broken jaws on several occasions. Such an injury is usually fatal for the predator. A lions’ success at hunting depends on a variety of environmental factors and the method of hunting. Overall, running by a single lion is successful only about 8% of the time. When stalking or ambushing, a single lion kills on about one in six attempts, but if two lions hunt together they succeed once in about three hunts. Clearly, even though most of lions’ hunts will fail, their success rates are sufficient for them to survive and procreate.

Decision-making in predators and speculators

One component of a predator’s hunting that we can not observe, but which is clearly operative in every healthy animal’s brain, is the decision-making process that directs her predatory behavior. Without a doubt, this is a sophisticated and highly complex mechanism, but for our present interest, I’ll only discuss those elements that parallel the speculative activities of traders. As we have seen, lions pass much time watching their environment for an opportunity to catch prey.

When actively hunting, a lion keeps track of a variety of factors to determine when to launch an attack. The size of her prey must be large enough to justify the expenditure of energy in hunting, but must also not be too large for her to tackle safely. She must also make a judgment about an animal’s state of fitness and focus on the most vulnerable individuals.

She must also take her own fitness, speed and endurance into account, as well as a myriad of environmental factors. She may only charge when she is highly confident that her hunt can be successful. At that point the decision to launch the attack is made and she charges with full force. Her decision-making doesn’t stop there however; the lion must conserve energy and abort her hunt as soon as her confidence in making a successful kill drops below some threshold. Then the process starts over.

In terms of decision-making, a lion’s predatory behavior is similar to a trader’s speculative behavior. The speculator spends much of his day scanning news, analyses and commentary about securities markets in order to identify attractive investment opportunities. Some opportunities or trade ideas may catch his attention and he then studies them more closely. When he is very confident that he can make a profitable trade of it, he buys or sells some quantity of the asset in question and assumes the risk in holding it. From that point on, he monitors his position to make sure it’s unfolding as expected. But at this stage of the “hunt,” the behavior of speculative traders differs sharply from that of nature’s predators. Predators are masters of conserving resources and cutting their losses. They can always afford to abandon failed attempts because their survival depends on the cumulative result of the total of their hunts rather than on the outcome of any individual attempt. By contrast, speculators tend to treat each transaction as a departure from status quo and are burdened with a hardwired loss aversion bias. If markets go against them, rather than cutting their losses, traders tend to gamble with them and escalate risk hoping that things will turn in their favor. This doesn’t always happen, and most speculators end up losing. Many squander all of the resources at their disposal and ultimately eliminate themselves from the pool of market participants.

Nature’s risk management

Looking deep into nature also suggests a solution to the problem of risk. Risk is not the same thing as uncertainty. Uncertainty means that we simply cannot predict the future. Uncertainty also can’t be quantified in a meaningful way. By contrast, risk can be quantified and measured. In simplest terms, risk tells us how much we can lose if we bet the wrong way. If we make small bets, we risk small losses and if we make large bets, we can lose big. Nature has resolved the problem of risk to life on Earth through fragmentation of risk and diversification of species and individual agents.

This principle is appropriately encapsulated in the maxim, “no tree grows to the sky.” While every species strives to grow, this is not done by infinite growth of individuals but by their multiplication at a certain – probably optimal – size. Thus, lions grow to about 115 kg for females and about 180 kg for males. If they are successful as predators, they will raise many litters of cubs. When fully grown, younger lions will establish new prides and spread as widely across the Earth’s surface as they can. Competition for habitat and resources is the main business of every species on Earth and the cumulative result of their actions has been the spread of life throughout the biosphere.

This diversification of life and its constant renewal as mature generations beget young generations has also enabled life to be perpetually adaptable. As conditions in a habitat change, life adapts by varying the genetic expression of species in their successive generations. Thus, even with perishable individuals and extinguishable species, nature has been able to sustain life for over three billion years and will probably continue to do so indefinitely as long as the conditions on the planet allow it.

The challenges encountered by natural life seem compatible to those we must address in financial speculation. In this way, natural life offers us coherent answers to the problems of uncertainty, risk, growth and adaptability. Truly, by looking deep into nature we may understand everything better.

 

The above is an adapted excerpt from my book,

Alex Krainer is an author and hedge fund manager based in Monaco. Recently he has published the book “Mastering Uncertainty in Commodities Trading“.

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