Survival of the Fittest for Investors: Using Darwin’s Laws of Evolution to Build a Winning Portfolio

By Dick Stoken

The science behind creating portfolios that adapt to market changes

“After ten years of poor stock market returns and yet great bond and gold returns, there is a real thirst for an all-weather portfolio in a high-risk period. Dick Stoken builds that diversified portfolio and also introduces some timing methods to improve returns and lower risks. This is a very timely and useful book.”
—Ned Davis, Senior Investment Strategist, Ned Davis Research, Inc.

“Dick Stoken’s Survival of the Fittest for Investors is a masterful and unique dissection of what makes the market tick. It represents an indispensable and brand-new approach for the serious investor. A must on every investor’s reading list.”
—Leo Melamed, Chairman Emeritus, CME Group

“I selected Stoken’s Strategic Investment Timing as the Best Investment Book of the Year in the 1985 Stock Trader’s Almanac; Survival of the Fittest for Investors will be a leading contender for Best Investment Book of the Year in the upcoming 2013 edition.”
—Yale Hirsch, founder, Stock Trader’s Almanac

About the Book:

Just as the animal kingdom is composed of many species, today’s financial systems are composed of a multitude of independent participants, all over the globe, all influencing the whole. Survival of the Fittest for Investors breaks down the science behind the behavior of these market participants to present a definitive system for building profitable portfolios based on the concept of natural selection.

This advanced guide to the cutting-edge science of complex adaptive systems in financial markets tells you where to find and how to track the evolutionary instability underlying these markets. It shows how, with heightened insight and a powerful algorithm, you can survive and thrive in volatile markets by following the simple principles of evolution.

Award-winning and critically acclaimed author Dick Stoken punches holes in the outdated, Newtonian cause-and-effect paradigm and helps you see financial markets from a Darwinian perspective, where they function as complex systems that have the ability to adapt. By using his state-of-the-art algorithm, Stoken demonstrates how you can use agent-based modeling to assess the actual way markets behave in order to maximize the upside of your asset allocation.

Stoken shows that variation is the key to profitability by using three real-world portfolios, each balancing four major asset classes going back thirty-nine years. Each portfolio clearly demonstrates how to reap consistently impressive profits with lower-than-market risk—regardless of your investment style.

Whether you take conservative, traditional, or leveraged positions, this book helps you create portfolios of equities, debt, gold, and real estate that have proven to beat the S&P 500 by up to 22.5 percent!

After opening your eyes to the science of complex adaptive systems and the vitality of punctuated equilibrium, Survival of the Fittest for Investors helps you implement the know-how into nuts-and-bolts results by equipping you with such practical tools as:

• A 1-year/6-month algorithm for accurately simulating evolutionary fluctuations in markets
• A cutting-edge allocation strategy that takes advantage of our natural “herding” instinct
• Tips for recognizing and enduring “bubbles”

Without Survival of the Fittest for Investors, the evolution of investing may leave your wealth behind.

• Language: English
• Publisher: McGraw-Hill Education
• Release date: Dec 9, 2011
• ISBN: 9780071782296

Book preview

SURVIVAL

of the

FITTEST

for

INVESTORS

USING DARWIN’S LAWS of EVOLUTION to BUILD a WINNING PORTFOLIO

DICK STOKEN

Copyright © 2012 by Dick Stoken. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.

ISBN: 978-0-07-178229-6

MHID:      0-07-178229-X

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THE WORK IS PROVIDED AS IS. McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise.

To my grandparents, Benjamin Stoken, Ester Kite, Betty Twersky, and Harry Ogens, who crossed an ocean and settled in an alien culture to provide their descendants the promise of a better life. I hope the book is worthy of you.

CONTENTS

ACKNOWLEDGMENTS

PREFACE

PART 1

THE ORIGIN OF A NEW INVESTMENT STRATEGY

CHAPTER 1

The Investment Game

CHAPTER 2

The Investment Environment: An Ever Changing Landscape

CHAPTER 3

The Darwinian Alternative Framework

CHAPTER 4

The Stock Market Is a Living System

PART 2

VARIATION: THE FIRST IMPORTANT DARWINIAN INSIGHT

CHAPTER 5

An Alternative Investment Portfolio: Based on Variation

CHAPTER 6

A Passive Combined Asset Strategy

PART 3

FLUCTUATIONS: THE KEY TO UNDERSTANDING COMPLEX ADAPTIVE SYSTEMS

CHAPTER 7

Trends: The Central Feature of Our Investment and Economic World

CHAPTER 8

A Paradox in Our Investment and Economic World

PART 4

SELECTING ASSET CLASS FITS

CHAPTER 9

Critical Levels in the Stock Market

CHAPTER 10

Gold and Long-Term Treasuries: Buy and Replace

CHAPTER 11

REIT Estate Investment Trust Trends

CHAPTER 12

An Active Combined Asset Strategy

CHAPTER 13

Risk: Taking On More?

CHAPTER 14

The Twenty-first Century Real Estate Bubble

PART 5

A DARWINIAN WORLD

CHAPTER 15

The Agent Role in a Darwinian World

CHAPTER 16

How the Major Components of Search Engines Apply in Today’s World 209

CHAPTER 17

Conclusion: Don’t Sell Evolution Short

NOTES

INDEX

ACKNOWLEDGMENTS

Thanks to:

Larry Bernstein, Kingsley Stoken, and Deidre Stoken McClurg, for patiently reading my manuscript and offering many helpful suggestions. You made it a better book than it would have been.

Joel Weisman, my agent and critic of the first part of the manuscript, for pointing me in the right direction.

Robin Kramer, my faithful assistant, who was always willing and able to perform the numerous chores necessary to bring this project to completion.

Gary Crossland, for providing many of the statistical calculations used in this book.

Michael McClurg, who diligently assisted Deidre with the graphics which enhanced the book.

Finally to the lovely Sandra Loebe-Stoken, who gets the award for putting up with a mate totally absorbed in his project.

The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians. It looks just a little bit more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.

—G. K. Chesterton

PREFACE

After graduating from the University of Chicago, School of Business, some 50-years ago, I felt, oh, so smart. I thought I had become a member of a small elite group who really understood our world and had acquired intellectual tools to be successful in whatever I chose to do. In my case, it was to be a trader.

I found an excellent opportunity at the Chicago Mercantile Exchange, where for a nominal sum of money I could purchase a membership and trade directly on the floor. I would be able to use my trading skills to beat the heck out of the market, in that case, a commodities market. Well, it wasn’t as easy as I expected. Soon I recognized that all of my previous education was utterly useless in trying to outsmart a smart market. I realized that to survive and prosper in the rough-and-tumble environment of a marketplace, I would have to unlearn most everything that I had so painstakingly acquired … and discover skills more attuned to dealing with an uncertain future. In this venture, I was completely on my own, as there were no teachers or blueprints to follow.

Bit by bit, by trial and error, as I knew of no other way, I learned how a market worked, with its own peculiar logic—and how to master it. Without realizing it at the time, I had acquired a unique conceptual framework of how the world worked—opening the door to insights into other social areas, such as politics—that was quite different from the Newtonian logical, cause-and-effect construct that had been embedded into my brain from grammar school up through a prestigious graduate university.

I became successful enough so that I was able to retire, at the ripe old age of 31, and self-finance new endeavors. Yet when I tried to communicate what I had learned to others, outside of a few peers at the commodities exchange, I would only elicit glazed eyes or blank stares. You see the language for my new conceptual framework was in my head only, and I lacked a proper vocabulary to articulate it. Even most of my peers were only interested in my conclusions: Is the market headed higher or lower?

In many ways I felt like a lost soul, able only to communicate about mundane things. When talking about more heady matters, I struggled to frame my ideas in a watered-down Newtonian vernacular. It was terribly unsatisfying, as most of the time I was not able to relay to others what I really thought.

Only a few years ago, I discovered the existence of a new science. While browsing a London bookstore I picked up a book, The Origin of Wealth, by Eric D. Beinhocker.¹ I started reading it immediately, and my unarticulated ideas bubbled to the surface. I read through the night and into the next. Finally I had found a home for those long-buried notions; I had found a language and an organizational structure through which they could be expressed.

The concept that so tantalized me is called complex adaptive systems (CAS): it is a new science that is just now beginning to emerge. Actually, it is more than just a new science. Like the Newtonian intellectual revolution, this idea has the potential to become a new mental construct, as Beinhocker states, the prism through which we conceptually view our universe. CAS, in part a critique on the Newtonian mental construct vigorously publicized by Mr. Beinhocker, is still in its embryonic form. Though the world has not yet taken much notice of the concept, take heed, as it is showing signs of intellectual vigor.

In the mid–1980s, a school in Santa Fe, New Mexico, called the Santa Fe Institute, was founded to study this new science. New curriculums in complex adaptive systems have already been established at several leading universities, including the University of Michigan, the University of Virginia, and Northwestern University.

In its simplified form, CAS proponents maintain that the Newtonian worldview, which so captivated Western societies after Sir Isaac Newton’s seminal discoveries about the motion of heavenly bodies, had hit a brick wall. CAS people readily concede that the Newtonian logical cause-and-effect construct played an immense role in propelling Western societies to the forefront of modernity. It enabled us to create precision machinery of all kinds, from trains to planes; it provided a foundation that led to the building of rocket ships capable of taking man to the moon; and it laid the groundwork for our enormous strides in beating back and, in some cases, defeating disease. However, because of that very success we thought it could also be the vehicle to master other areas, such as economics and investing. But in those endeavors, the Newtonian construct has proven to be a dismal failure—one has only to survey the carnage from the financial crisis of the late 2000s that our economic leaders told us could not happen. However, repetitive errors didn’t stop us. After each blunder we kept thinking we were just one repair job away from mastering those areas, as we had with the hard sciences.

In a nutshell, the Newtonian construct has allowed mankind to acquire a knowledge of linear, cause-and-effect relationships and use them to create mechanical entities, wherein all the interacting parts could be programmed to act in preset ways so that outcomes were highly predictable, for example, airplane accidents are few and far between and the rare mishaps that do occur are identified and fixed so as not to be repeated. As long as the parts to a system are inanimate, this approach works remarkably well. But when the components of a system are humans, as they are in the stock market and the economy, or say a political system, this approach breaks down. This happens because humans are intelligent; they learn, they adapt … and they cannot be programmed or directed to act in a specific way that will produce a reliable outcome.

Complex adaptive systems built around humans must be approached in a different manner. They are, as their name implies, complex. The large numbers of components that make up the system interact in a non-simple way. There are too many connections to properly understand all of the relationships, which are also continually shifting. And the models the experts build in trying to grasp and analyze these connections are imperfect, and inevitably break down. To understand these systems, we must look for a window to peek inside. And that window is the self-regulating fluctuations, which occur in a trend-like manner.

That is what this book is about: understanding the trends which are the basic mechanisms that underlie stock market movements. In this book, I will teach you how the stock market works and introduce an algorithm, based on these concepts, that has outperformed the stock market on both the return and, even more importantly, the risk side for almost a hundred years.

I will take you on a journey to places conventional financial professionals have not yet visited, to see things you haven’t seen before. By the time you emerge at the finish line you will have an entirely different and postmodern way of viewing the stock market—a new investment cosmology. Come with me on this journey.

PART 1

THE ORIGIN OF A NEW INVESTMENT STRATEGY

Investment markets are joined at the hip to our economy, forming a great wealth-creating system, which we celebrate as free-market capitalism.

We are going to build an investment strategy to exploit our wealth-generating system on principles from evolutionary biology. As we shall see, this robust strategy has proven both more profitable and far less risky than most contemporary stock and bond strategies.

CHAPTER 1

THE INVESTMENT GAME

Ever since 1792, when a group of stockbrokers, meeting under the now famous buttonwood tree on Wall Street, agreed to form the New York Stock Exchange (NYSE), people have been trying to master the investment game … but with little success.

Sure there have been winners! But in paraphrasing the words of Warren Buffett, head of Berkshire Hathaway and the most quoted investment guru of our time: imagine several million chimpanzees that had been taught to flip a coin, assembled in some immense stadium to participate in a chimp super coin-flipping contest with the media present. As the field narrowed, anxious media members breathlessly interviewed the finalists, asking them, assuming they could speak, what was the basis of their superior coin-flipping skills. And the chimps, honestly believing they possessed some special skill, would credit their success to a particular way of flicking their wrist, or perhaps to repeating some mantra while flipping. The public, meanwhile, listening to the commentator’s excited rendition of the chimps’ abilities, would believe that practicing such wrist flips or chanting magical mantras led to the chimps’ success, and then would try to do the same.

Dear Reader: What if yesterday’s and today’s acclaimed stock market wizards are no different from a group of chimpanzee finalists?

Sounds silly? Agreed; it flies in the face of the way we Westerners like to think. We are children of a Newtonian mechanistic worldview. More than 300 years ago, Sir Isaac Newton excited our ancestors by solving the problem of the motions of the planets and, in doing so, birthed a new way to look at the world. The Newtonian mechanical worldview championed a chain of cause-and-effect logic and it became the blueprint for a large-scale search for knowledge. As Westerners sought to match cause and effect, identifying a cause for every effect and potential effects of any cause, they created a clear pattern of thinking that allowed us to master problems that had baffled mankind since the ancient Greeks. Over the following centuries, men and women vastly increased our collective store of knowledge; they figured out how to build spaceships that were able to take astronauts to the moon; they invented machines that spearheaded enormous leaps in our world’s material wealth; they found cures for numerous diseases that had formerly cut short much of human life; and they designed a system for citizens of a political entity to govern themselves through representatives.

All this is certainly true, yet, whether or not this same type of knowledge can be translated into models that will allow us to reliably predict the future is questionable. Respected observers insist that in the long run the stock market cannot be beaten. This means that over time the participants, including so-called experts, will be unable to better an average return obtained from investing in an index of stocks, without taking on a greater amount of risk.

IS THE MARKET BEATABLE?

At the beginning of 1970, there was a haystack of 355 equity funds. We can