Tuesday, March 27, 2012

The Evolution of Strong Groups

Recently Falkenblog pointed to a study he came across in Jonathan Haidt’s book, The Righteous Mind, on the dynamics of group selection in evolution. This study relates quite strongly to the mechanics that we have discovered work best for selecting investment portfolios over time.

Systematic investing is really starting to feel its oats; many investors and Advisors, both retail and institutional, are beginning to realize that a thoughtful, mechanical approach to investing is required to short-circuit the dozens of biases buried deep in our wetware, and which sabotage our best efforts at rational decision making in markets. However, the vast majority of systematic investors apply rules and screens to find the top individual assets or securities according to a specific criteria, which they assemble in portfolios, usually in equal weight. It turns out this may not be the optimal approach.

Haidt describes a study whereby a group of geneticists worked with hens to improve egg yields. In a twist on traditional breeding techniques, where individual organisms with strong target traits are bred together to create a 'super-breed', the geneticists focused on how egg production improved or worsened depending on how the hens were grouped. Working with cages containing twelve hens each, they identified the cages with the highest aggregate egg yields, and inter-bred the groups of hens in the highest yielding cages.

The results?

It turns out that breeding the individual hens with the highest egg yields created hyper-aggressive hens which, when placed in a population of other high-yielding but hyper-aggressive hens, peck each other to death, which in turn causes total egg yields to drop.

However, groups of hens with high aggregate yields contain the right mix of high yielding hens and passive hens, such that when high-yielding groups were inter-bred, the resulting new groups contained even more concentrated versions of both traits, with incredible practical results. Notably, within 6 generations of group breeding, eggs produced per dozen hens rose from 91 to 237, for a 260% improvement.

Our approach selects baskets of assets which work well together to deliver strong stable returns. Importantly, this does not mean that portfolios contain the strongest individual assets; if strong assets possess qualities (correlation or volatility traits) that do not complement the other members of the group, they are not selected. This is critically important and is the conceptual root of our strategy's outsized return/risk ratio.

To see how this applies to your portfolio see here:

Darwin Investment Strategy
Retirement's Volatility Bogeyman

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