Why I am talking about cockroaches on a finance blog? I hate cockroaches. They are top in my list of disgusting and obnoxious insects. Despite that, they are the topic of the discussion today because they have admirable risk-management skills, as noted by Richard Bookstaber in his book “A Demon of Our Own Design.”
Cockroaches are ancient insects that have existed very successfully, relatively unchanged, for at least 250 million years. This means that they have inhabited earth 100 times longer than humans and predated the dinosaurs by about 15 million years. They have survived through many unforeseeable changes – extinction of dinosaurs, ice age and other catastrophic climactic changes, and changing predators that have come and gone over the course of its lifetime.
Richard Bookstaber points out that “Its not only remarkable that the cockroach has survived so long, but it has done so with a very basic and somewhat suboptimal mechanism. Its defense mechanism is limited to moving away from slight puffs of air, puffs that might signal an approaching predator. It ignores a wide set of information about the environment – visual and olfactory cues, for example – that one would think an optimal risk management system would take into account. The rule that cockroach obeys is so simple that it depends on its giant fiber nervous system; it is a reaction that does not need to be filtered through the brain, but rather goes directly from the sensory hairs that detect the puff of air to the thoracic ganglia controlling its leg motion.”
He further contrasts the extremely coarse risk management structure of the cockroach with that of the furu, a once-dominant fish in Lake Victoria in the middle of Africa. “The furu is a good example of how a specialized creature can be defeated by unanticipated environmental changes. Lake Victoria is the world’s second largest freshwater lake, size of Ireland, in east-central Africa. Even though it is huge, it is relatively shallow with an irregular coastline of countless inlets and swampy bays. Living in protected isolation in this vast and varied habitat, the small perch like furu specialized to a remarkable degree, diversifying from a single species over the relatively brief 12000-year life of the lake to at least 300 species, ranging in size from 4 to 12 inches. There are furu that survive as scavengers living off of the organic waste of the lake bottom; algae scrapers that feed off of shoreline rocks; snail crushers that have developed long teeth to pull the snail out before it can fully retract into its protective shell; larvae eaters that sift insect larvae out through mouthfuls of mud; prawn eaters that inhabit the deeper waters where the prawns live; and “child eaters” that eat the newly hatched child of other furu just after they are released from their mother’s mouth, or in some cases by first ramming the mother to dislodge the eggs from her mouth.
For the biologist, the furu of Lake Victoria rival the finches that Darwin studied in the Galapagos Islands. In the summer of 1954, the lure of the lake to the naturalist changed forever by the actions of a Kenyan game fisheries officer with a bucketful of Nile perch.
Unlike the diminutive furu, the Nile perch can weigh upwards of 100 pounds. In the mid 1950s, the fish was introduced to other African lakes with spectacular results: Commercial fish production rose tenfold in just a few years. But these other lakes contained species of fish that had time to adapt to the Nile perch or had habitats where the Nile perch did not tend to go. Neither of these conditions turned out to be the case in Lake Victoria.
In the two decades following the initial stocking of Nile perch in Lake Victoria, naturalists who were following the furu found that they were increasing pulling Nile perch out of their nets. Soon the only place they came across the furu was in the stomachs of the predatory Nile perch. It seems the furu did not know what hit them. Defenseless and apparently clueless to the voracious predator that had been unleashed in their midst, they were rapidly becoming extinct. But their impending extinction was not the result of natural selection based on fitness in the usual sense; they were diverse and suited for almost every conceivable element of the Lake Victoria ecology.There was, however, one component of behavior where this was not so, a component that had not mattered at all in the thousands of years they had inhabited the lake but that made all the difference once the Nile perch was introduced. With the exception of a few of the insect- and snail-eating species, the furu at some point in their life cycle move out of the littoral areas and head for the open waters. Because it is such a large fish, the Nile perch tends to stay in deeper waters, so the furu fish that stay near the shoreline, inlets, and rocks might go their whole lives without running into one. For Lake Victoria, that represents a lot of secure real estate. But the furu had never had any evolutionary need to distinguish between the shallow coastline and the deeper waters. This did not represent a failure of fitness or an inability to adapt to its environment. Its path towards extinction was just a result of the dumb luck that someone had introduced an alien species into its waters.
The cockroach and the furu are two of the many examples in biology that illustrate the benefits of coarse behavior and the perils of fine-tuned behavior in reacting to a broad range of natural uncertainty. The coarse response, although suboptimal for any one environment, is more than satisfactory for a wide range of unforeseeable ones. In contrast, an animal that has well-defined and unvarying niche may follow a specialized rule that depends critically on that animal’s narrow perception of the world. If the world continues on as the animal perceives it – with the same predators,food sources, and landscape – the animal will survive. If the world changes in ways beyond the animal’s experience, the animal will die off. Precision and focus in addressing the known comes at the cost of reduced ability to address the unknown.”
To carry Bookstaber’s biological case study into the capital markets, value investors are the “cockroaches” of the investment world. They eschew leverage, invest only when the price is cheap in securities that have sufficient collateral. Just like the cockroach, their behavior is coarse and suboptimal, especially in rising markets. But, these cockroaches can and will survive through many catastrophic changes.
The furu, on the other hand, is akin to to today’s highly leveraged investor seeking to eradicate risk by fine tuning portfolio using complex math that only a PhD can understand. With risk so theoretically constrained, the “furu” of the investment world use leverage to exploit small market inefficiencies. But, their approach is similar to “picking up dimes in front of steamrollers." Just like the furu, their extinction is assured when an alien predator comes fast and furious in their lake !
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