Evolutionary investing

Most investors spend too much time worrying about missed opportunities. That’s my strong suspicion, at least. A process of reflection is important, without doubt, but more attention should be focused on mistaken purchases rather than regretted non-purchases. Mistakes are costly facts. Missed opportunities, however, are winners you’ve selected after the fact which have come from a pool of potential investments that also included many also-rans and disasters avoided.

There might be a useful analogy in a decade-old book called Unweaving the Rainbow, an enjoyable polemic by evolutionary biologist, science writer and provocateur Richard Dawkins.

He talks about the strategies available to an animal with high metabolism, such as a small bird, which needs to find food ‘alarmingly often in order to stay alive’. He asks us to imagine that bird ‘cruising around a wood, looking for prey. It is surrounded by twigs, a very few of which might be edible (well camouflaged) caterpillars.’ The bird could successfully distinguish between twigs and caterpillars ‘if it approached the twig really close and subjected it to a minute, concentrated examination in good light.’

Survival of the most efficient

So what strategy would that bird employ to keep its tummy full? Dawkins says that the bird cannot scan each twig with the ‘equivalent of a magnifying glass’ or else it would starve before locating its first caterpillar. ‘Efficient searching demands a faster, more cursory and rapid scanning’ even though this process inevitably means missing many caterpillars. The bird has to find the right balance: ‘too cursory and it will never find anything. Too detailed and it will detect every caterpillar it looks at, but it will look at too few, and starve.’

Do you see the parallel for investors? If you substitute ‘investor’ for the small bird; ‘successful stockmarket purchase’ for a caterpillar; ‘poor investment’ for wasting time on a twig; and ‘maximising returns’ in place of maximising calories, then the analogy explains my suspicion quite effectively.
To the extent that this analogy is accurate, optimal investment returns will come from a strategy that leaves plenty of tasty opportunities untouched. There’s just no point fretting over missed caterpillars, or stockmarket opportunities.

A few pages later, Dawkins explains that the ‘parts of our brains responsible for doing intuitive statistics are still back in the stone age’. Apparently, in most situations humans display a tendency towards making more false positive errors (also called ‘type 1’ errors, which would include buying a stock that turns out to be a dud) than false negative errors (such ‘type 2’ errors would include missing a good opportunity). And when hindsight bias causes us to regret the latter form of error, it further encourages more of the former type that we’re already predisposed to. In other words, fear of missing out on the next CSL may lead an investor towards the next Chemeq.

Unweaving the Rainbow explains Dawkins’ theory for why humans have evolved this way. But for us, the key lesson is that successful investors have inevitably found a way to recalibrate this bias. They are, almost to a rule, more concerned with avoiding mistakes than they are with grasping every opportunity that comes their way.
Some investors even actively embrace false negative errors (missed opportunities), finding it the most effective way to reduce false positive ones (poor purchases). For example, we don’t at all regret missing the run up in BlueScope Steel’s share price from a few bucks to more than $10 earlier this decade – not because we dislike making money but because we feel it could too easily have gone the other way (as the share price has more recently).

Results are driven by what you actually do, rather than what you don’t do. If you’re only interested in the biggest, juiciest, most certain caterpillars, then missing others isn’t a cause for concern. So don’t unduly stress over missed opportunities, but go out and try to spot more. Just take a much closer look before you bite.