The ecology of risk

Financial stability can benefit from approaches grounded in the natural sciences.

“Nothing in biology makes sense except in the light of evolution.”

This statement, the title of an essay by evolutionary biologist T.G. Dobzhansky, was published in “American Biology Teacher” in 1973. It properly asserts that evolution is the cornerstone of any meaningful dialogue in the biological sciences, stressing the importance of ecological theory in understanding biological system behavior.

We can extend this ecological theme of interconnectedness to modern financial and commercial activity, where we can just as easily state: “Nothing in economics makes sense, except in the light of ecology.” Large-scale events that have disrupted energy, agricultural and material supply chains in recent months underscore the importance of viewing the world through a spatial lens.

With each passing decade, as new manufacturing and production origins have come online, the barriers to entry that for many years had prevented the functioning of a true global economy have slowly been dissolving. No industry or country can now be considered immune to the financial fallout stemming from supply disruptions. While globalization has most certainly provided much of the world with many benefits, from cheap, reliable energy, food and telecommunications, to an ever-expanding universe of choices to enrich our lives culturally and materially, the increasing number of choices is accompanied by a more fragile economy, susceptible to perturbations.

So while we continue to enjoy the aforementioned benefits of a connected economy, we need to recognize and appreciate the potential magnitude of the underlying risks. The global raw material supply chain is now spread out very thinly. So much that when even the undocumented news of a potential threat to the supply of particular materials sends ripples through the markets, affecting in near real time both the price of the material in question and the equity valuations of those in the exposed industries.

Effectiveness graph
Image from Gary Horvitz

Darwin meets the Fed

As such, perhaps it is now time to take a more serious ecological or geographical approach to risk as it pertains to global commerce. Nassim Taleb repeatedly argues that the financial system needs to robustify. Using nature as a metaphor, Taleb maintains that mother nature is redundant, and the financial system should employ similar measures of redundancy to avoid blowing up. Multiple layers of protection are necessary to protect against shocks. While this redundancy can limit the swings to the upside (much to the chagrin of many fund managers ), it also spreads out the risk when the negative events inevitably arise, minimizing the disastrous consequences.

Theoretical biologist (and former managing director at Deutsche Bank) George Sugihara also calls for ecological principles to be included in more comprehensive risk management and mitigation strategies. Drawing from Sugihara’s own research into fishery management and collapse, he suggests that the early identification of tipping points, rather than trying to model irrational investor behavior, may serve as a more effective means to alert economists to potentially significant market corrections. We may even go as far back applying some of the early ideas of Darwin, by taking into account the influence of selective pressures, and the subsequent nonlinear nature of the evoked response.

Natural capital

These are just a few of the many instances where modern economic analysis and the goal of financial stability can benefit from approaches grounded in the natural sciences. This is a theme that has certainly been around for a long time, but I don’t feel that it has ever been taken seriously by those outside of academia. For risk managers striving to protect either natural or financial capital (or both), the need to appreciate not only the connections within a system, but more importantly their underlying geographical opportunities and constraints, is the first step in robustifying markets. Therefore, instead of trying to export theories of what prudent investors would or should do according to standard economic theory and structuring positions to capitalize on these assumptions (efficient markets are actually a fallacy), when a market-moving event commences, a robust strategy grounded in ecological principles will survive, and over the long term have a better chance at providing a healthy return.

While the risk manager may not be able to prevent the initial shock to the market, he or she may be able to better anticipate the potential effects, and in the process, properly construct a hedge to avoid the consequences. On paper, the job of the modern financial risk manager is to preserve capital, striving to maintain positive returns while minimizing drawdown. In practice however, the risk manager is as much a speculator as the head trader. To compound the increased risk for a collapse, most fund managers are watching their radar for the same potential risks. When an event surfaces and catches the market by surprise, (ie., Australia floods, Argentina drought, MENA civil unrest, increased volatility in oil prices, Japan earthquake, etc.) almost everyone loses. Will an approach that is partially resistant to such shocks limit the upside, curbing the potential bonus of a fund manager? Absolutely. But it will also ensure that the fund manager is still around to enjoy the capital they are paid to preserve and grow.

Only a truly diverse portfolio can be considered stable or robust. As in large scale-agriculture, monoculture may work for a while, but eventually, diversity wins.

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  • http://twitter.com/beaucronin Beau Cronin

    Interesting. But how do you incentivize the financial players to do so – in the current system, these redundancies will be viewed as inefficiencies. In the short term, the fragile system is best, especially when large losses are socialized.

  • Alex Tolley

    This view of ecological robustness is rather static.

    Consider that evolution is often fostered by the fact that ecosystems are not that robust, but prone to periodic collapse. Indeed, our own human evolution was probably dependent on the removal of the dinosauria from all ecosystems. Our economies are similarly disrupted by change, which can be very beneficial compared to more robust systems that are resistant to change.

    Be careful what you wish for…

  • Michael Ferrari

    Robust is not the same thing as being resistant to change….Robust systems are stable, and (can) evolve as a function of change, and are therefore sustainable.

    Ecosystems not that robust? Only 6 mass extinctions in between 3-4 bln years of life on the planet would argue otherwise.