Evolution

Today's Finance is still in its infancy as a science. The domain of what we know pales in comparison to what we actually know we don't know. For example, we know that our understanding of the basic mechanisms of asset valuation (stocks, real estate, gold) is limited, confused and non-operationalfor the most part. Who can tell and predict the value of stocks today? Investors are offered conflicting views (rational vs. irrational), quick recipes, and voodoo advice. The "pseudo" scientific mathematical models that are offered today, far from resolving real-world problems do revel in their own complexity in exchange for minor incremental learning. Below, I am addressing several outstanding issues in Finance. Let me give you a few examples of major unresolved issues:

· The CAPM dead or alive? Over the last few decades one of the most prominent model of Finance called the CAPM has been under attack, not because its logical foundations are wrong or limited, but rather since it does not explain returns, the way it was intended to: higher contribution to systematic risk leads to higher returns. Noteworthy, is the French-Fama (1992) paper showing that price to book is a better predictor of stock returns than beta. Now, we can accept that an essentially static model created about 40 years ago can fall short of explaining reality. Maybe the reason is that we are not capturing expected returns properly. Recently, there have been new attempts to validate the model (for example showing that a form of inflation illusionhas an effect on the Beta-expected return relationship (Cohen, Polk and Vuolteenaho (2004)), or that the French-Fama result can be explained by incorporating leverage as a factor, thus rendering the beta effective again (Ferguson and Shockley (2003)). These results may be incrementally informative but it is important to know if the stream of new insights about CAPM is fundamental enough to repair the model.

· Beta only a measure of risk? Beta measures the contribution of a single stock to market volatility. One of the confusing piece of language about it is that it is supposed to represent risk. However, in some instances it may rather represent growth. For example, since the stock market moves upward in the long-run, and market returns are positively serially correlated (low frequency data), then a high beta stock may in fact capture a boost to the average market return due to faster than normal growth (in earnings). The extra premium is not for risk but for growth. Here are some new views about redefining the standard CAPM model in terms of beta linked to downside risk (Kaplansky (2004) or Post and Van Vliet (2004)).

· What about those macro-finance models? Since the static model has not done so well, what about the dynamic models? These have not fared better since the middle of the 1970's (essentially since the works of Merton (1973) and Lucas (1978). Both are Nobel laureates in Economics).

· Valuation of stocks, anyone? The standard dividend discount model taught in our schools (and many variations on it) has not borne its fruits. Stock prices MUST be based on the present value of expected future cash flows accruing to investors (Warren Buffett concurs). The questions are: 1) Are these cash flows adequately represented by forecast dividends or proxies? 2) How do we account for expected price appreciation independently of future dividend proxies? 3) How can we narrow the choices for the right discount rate(s) and other inputs to apply to these models? Still, it appears that demand often forces prices to temporarily diverge from a present value calculation due possibly to "irrational exuberance", then 4) How fast does the reversion mechanism to fair value operate (if any)?

· Is the stock market rational or irrational? This is a very confusing issue since the latest conventional wisdom is that the stock market is mostly irrational (Shiller 2001). In fact, it is probably a mixture: an undercurrent of fundamental value plus superimposed short-term deviations due to irrational behavior and/or news. Let us be careful though, one reason why markets are seen as irrational is that Finance has been unable to provide a logical/mathematical foundation to valuation since the current models have fallen short. Thus, our definition of "rational" is contained within the rationality of the models we have so far developed. The core guiding principle of investors' decisions may very well be founded on economic laws (systematic and reproducible) left to be discovered…

· What are we (investors) to do? If markets are irrational what is there to learn about investing in stocks? Are we investors supposed to throw in the towel when there is no solid ground on which to make a stock investing decision? Maybe some investors can capitalize on the irrationality of other investors? (Contrarian trading: Am I irrational or is she?). On the other hand, you'll say there is always the motto of Value Investing: buy companies for which you understand the business model, scrutinize the financial statements, do they have a good cash position, low PEG, etc… There is no argument that these factors can contribute to good stock selection. More to the point though: an entire industry has sprung-up not necessarily caring about how stocks are truly valued. Yes, I'm talking about the mutual fund industry. How so? The industry creates portfolios with particular flavors: Growth oriented, Large caps, Small caps, Blends etc... The game in town is product differentiation and finding a market niche. A marketinggame! Since no one truly understands the pricing of stocks, mutual fund managers attract investors by promising to replicate 'good' past records, or to generate great returns based on the fund's investment style (an oxymoron). Since portfolios are turned over to dump losers and buy winners (often late), these outfits are not in the business of fully understanding stock valuation but rather in the business of maintaining or growing their fund participation by minimizing quarterly losses and riding the growth endemic to a capitalistic economy.

· The (in)famous Equity Premium puzzle. The Equity Premium (EP) is the difference between the stock market return and a Treasury yield (also referred to as risk free rate). Now, if there were an equivalent to the speed of light in E = MC2, as applied to the valuation of most assets, this would be the EP. However, the EP is typically not constant over time. It is what economists call counter-cyclical: it rises during recessions and lowers during booms. Now, since stocks are riskier than bonds in the short-term, following the CAPM logic they should pay a higher return. Thus, the EP should be explained by risk avoidance. However, the current macro-economic and finance models are unable to confirm this intuition, since (not to bore you too much) the size of actual equity premium does not reconcile with what the models need to assume for the level of risk aversion in the economy. Recently, Bansal and Yaron (1994) have had some success in reconciling our economic models with the ctual size of the premium. However, their solution is a bit strange: in order for their result to hold investors have to be worried about minute variations in long-term GDP growth, by an order of few basis points (1% of 1%)!

· Stock returns that compound faster than economic growth? No kidding! Current theories accept that compound equity returns have been around 11% nominal in the long-run. This far outpaces the nominal GDP growth of the US economy about 6.5%. Imagine a savings account paying 11% when the bank's profits only grow at 6.5%… Why are current theories endorsing this result? Well, the key to this gap is that the equity compounded return calculation assumes that dividends are fully reinvested period after period. A single investor may be able to do this for a while as he/she can increase their market share, but since aggregate stock wealth cannot grow faster than GDP in the long-run, all investors at large cannot do that. The pricing of stocks must incorporate a relationship to feasible wealth compounding. Right now, the current theories do not link returns to GDP growth in a convincing manner.

· Loving or fighting the Fed model. The Fed model (Orphanides and al. (1997)) is highly controversial. Many practitioners love it (see Dr. Yardeni's page); academic pundits hate it (Asness (2003)). The Fed model is the result of a discovery that the SP 500 forward earnings yield is highly correlated with the 10- year Treasury yield, since the 1970s. This is the best working model we have for the SP 500. Academics believe the model is logically flawed, based on thinking that the earnings yield is a real rate of return. Yes sure, how can you compare a real rate to a nominal yield? Since the Fed model is flawed, the observed correlation must be a fluke and since reality violates our current accepted theories, then reality must be wrong! (This is an actual quotation!) Well, try to tell that to practitioners! We must attempt to better understand why the Fed model works.

We need to view ourselves much more like engineers or physicians, in our capacity as social scientists. We are living in exciting times, the science is young, the questions are still open, novel thinking and scientific breakthroughs await us.

Dr. Christophe Faugere is an Associate Professor of Finance at University at Albany School of Business Chair of the Finance Department. His research attempts at solving some of the challenging issues presented above. Please visit his website at wwww.albany.edu/~faugere.

Answer 1

Usually new species evolve from a common ancestor when, for some reason, there develops a decline in the frequency of interbreeding between two groups within the ancestral population. The decline in interbreeding causes increasing genetic divergence between the two groups, which in turn may act to further diminish the interbreeding frequency, which in turn leads to further divergence, and so on. If this continues, then eventually the interbreeding frequency between the two groups drops towards zero (or very nearly anyway), and would remain zero even if the two groups were put back together, and speciation can be said to have occurred.

There may be various causes for this decline in interbreeding. The mechanism that is simplest to explain is geographical isolation of two populations. Natural disasters or migrations, for instance, may cause two subpopulations of the same species to become separated from one another, so that interbreeding no longer takes place, and divergence can occur unimpeded. But there are also ways for divergence to occur in sympatry: between two groups occupying the same habitat.

Answer 2

According to DNA studies every biological event that causes changes to a species is from genetic losses and deleterious mutations.

You can see from early evidence that the oldest of any now living creature was far more complex and appears to be more fit for far more difficult environmental circumstances.

We have nearly 90% of the now living or recently extinct, non bird vertebrate, creatures as fossils. None of them appear to have crossed any lines of genus nor does their morphology appear so different that they are not recognizable as the same genus.

And we can see transitions back to these far more fit creatures. The Saber Toothed tiger degenerated and speciated to produce many of the cat lineages we have now. The path way of evolution is actually degeneration.

As creatures develop more and more genetic defects from mutation they are unable to breed when they are separated by land movements or like some modern mice by being dropped off a ship onto an island. There are also atavism which seem that if they are triggered by the environment like the Italian wall lizard was able to bring up an old gene (atavism) used to process vegetation and use that because the normal non-vegetable foods were sparse in this "new location".

It is this degeneration away from the parent species and the degeneration of the parent species that separates and stops reproduction.

The Chicken is said to have been from the "dinosaur" lineage and if you look at dinosaurs it is clear they were far more fit to survive in severe environments. The chicken has lost its teeth and shows in DNA teeth as an atavism. Scientists have been able to "trigger" that atavism and produce chickens with teeth.

In every case there is only degeneration shown in all DNA compared to the physical evidence.

In DNA studies on humans we have never found even on beneficial mutation to offset the 50,000 deleterious ones (estimated total to be about 100,000 world wide) we have amassed by our lifestyle choices.

There are certain types of (tribes of) human right now that have trouble reproducing. In the future as their mutations get them farther apart they will have a new species of human to deal with and have to come up with a new name, like "AlosHumans" or something to describe them as a separate species.

The chimpanzee is an amazing phenomenon that shows this very well. It is estimated from DNA and from ancient artifacts that chimps speciated from the human lineage about 4000 to 7000 years ago at best estimate. (There are no fossils of chimps indicating a small tribe and young tribe.)

The chimp is degraded to the point of extinction. If humans did not put them in preserves there would be none left. They are not smart enough, nor healthy/adaptable to defend themselves from human predictors, like moving up high in the mountains, to get away from humans and they don't reproduce but max of 3 baby chimps per female and 2 out of 3 die.

The process of (evolution) degeneration is clear, there are only 800 left in the wild and the rest are in cages or on preserves.

Our cousins apparently degenerated by 1/ mutagenic activities producing more and more diseases that attack them at the fetus level at the germ line and 2/ possibly move to an area with radiation or some toxin that caused these mutations that are destroying them.

Chimps should be a message to us about how we need to protect ourselves from spreading diseases, and causing more and more human suffering from our ignorance about how we are made.

Answer 3

Humans and other organisms are evolving not devolving. MRSA is an example of this. This is a normal skin microbe that has evolved the ability to not be affected by many antibiotics.