While listening to the latest RadioLab, “Speed” story about automating stock trading, I could immediately remember being in the kitchen, listening to NPR and hearing the updates on the crashing Dow. The flash-crash of May 6, 2010. Stock analysts were going bananas describing an unprecedented drop in the markets that was both incredibly steep and incredibly deep.
I wanted nothing more than to put any money we had into a Dow indexed fund – it was painfully obvious that this was just a computer problem and that it should correct soon (I thought perhaps over the next few weeks). Of course it was impossible to get into my ING sharebuilder account (a great saving device that everyone should have – I started mine as a poor graduate student putting just $50-100 a month into my account).
But the thing that really struck me as I listened was how like biological evolution the race for speed in stock trading is. It was mentioned that speed always wins in the market, the faster you are, the earlier you can act on key information and make easy-money trades to take advantage of
even minute swings in the price of stocks. (OK, an aside: I can’t ignore it, how is this investing? So much of this segment uncovered the truth about so much big money on Wall Street… it’s not about investing, it’s about taking advantage of the system and making money on glitches and technicalities. It’s not clear how this supports – or even has anything to do with entrepreneurial endeavors.)
The race for speed was compared to an arms race where warring parties take every opportunity to turn an advantage over their peers. But what about diminishing returns on these
investments? Can there be an end to this sort of arms race? Despite the apparent cost and distraction of focusing on details like the length of wire between your home office and the NYSE, the game is unavoidable. Why? Because it IS a game. And both game theory and evolution by natural selection can inform us about why these battles go on, and why they can’t end.
In game theory, there is the economic / trust game referred to as the prisoner’s dilemma. Here, I lifted this description of the game from wikipedia:
“Two members of a criminal gang are arrested and imprisoned. Each prisoner is in solitary confinement with no means of speaking to or exchanging messages with the other. The police admit they don’t have enough evidence to convict the pair on the principal charge. They plan to sentence both to a year in prison on a lesser charge. Simultaneously, the police offer each prisoner a Faustian bargain. If he testifies against his partner, he will go free while the partner will get three years in prison on the main charge. Oh, yes, there is a catch … If both prisoners testify against each other, both will be sentenced to two years in jail.”
The game’s outcomes are presented in this grid, making the dilemma clear:
Biggest payoff: convince others that you will keep your silence with them, then sing like a canary and go free while your friends rot in jail.
In this game trust is nearly impossible, but it is the only way both prisoners can benefit. But who can be trusted? Life would be so much easier if we could, but experience tells us that there will always be cheaters in games of trust and it’s best to bet on deception.
Why does this remind me of biology?
On the left, all trees ‘agree’ to keep to a set height and no one gets shaded out. On the right, one cheater takes advantage of the others’ trust and grows tall.
Because evolution works the same way. Every organism does everything it can to get ahead. Think of trees in the forest. If only the trees could come to a deal: “None of us will grow above ten feet tall. We can all save energy that way and be better off.” After all, the whole benefit in growing tall is to monopolize the sun and shade out your neighbors. But as soon as one tree breaks the bargain, all bets are off and the arms race begins again.
Amazingly, if the arms race is allowed to go on, a situation much like that depicted on the left occurs. The only difference is that all the trees have expended much more energy and they all stand taller, evening out at the point that physics and environmental conditions become limiting.